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KEMET Corp. (NYSE:KEM)

F3Q08 Earnings Call

January 29, 2008 9:00 am ET

Executives

David Gable - Chief Financial Officer

Per-Olof Loof - Chief Executive Officer

Analysts

Matt Sheerin - Thomas Weisel

Brian White - Jefferies

Shawn Harrison - Longbow Research

Jim Suva - Citigroup

Steven Fox - Merrill Lynch

Yuri Krapivin - Lehman Brothers

Andrew Huang - American Technology

Operator

At this time, I would like to welcome everyone to the KEMET results of third quarter operations conference call. (Operator Instructions)

Mr. Gable, you may begin your conference.

David Gable

Thank you and good morning. Welcome to KEMET’s conference call to discuss the results for the December quarter. I am Dave Gable, Chief Financial Officer and with me this morning is Per-Olof, Chief Executive Officer.

During this conference call, the company will be discussing matters which may be considered forward-looking statements that involve risks and uncertainties. These may be discussed in detail in the company’s filings with the Securities and Exchange Commission.

And now, I’d like to turn the call over to Per.

Per-Olof Loof

Thank you, David and good morning everyone. I would like to welcome you to the call this morning. And today, we will be reviewing the results from the December 2007 quarter. And we had a quarter filled with plenty of challenges and opportunities. Needless to say, we’re not pleased with our overall performance and as you might expect, actions are underway as we speak to rectify.

We did close on our purchase of Arcotronics early in the quarter and we are now moving forward quickly putting in a new management team, combining that business with Evox Rifa and thereby enhancing our Film and Electrolytic business group.

We continue to be very pleased with the performance of the Evox Rifa business and the initial performance of Arcotronics came in as projected. And we will assign the same principles of integration and speed now practiced twice in a very short period of time to bring the Arco business up to, and beyond those performance levels.

So, let me review some of the financial highlights for our fiscal third quarter. In the quarter, sales were $229 million, which is up 16% from the previous quarter of $197 million and up 38% to the same quarter of last year.

The Tantalum business decreased in revenues 5% from $108 million to $103 and that was driven by a seasonal reduction in sales of leaded parts but more importantly due to a higher mix of small case size parts, especially in Asia and with our EMS customers.

The Ceramic business, revenues decreased 8% from $59 million to $54 million and that was driven by lower volumes in the US as well as big changes in ASP erosion in Asia. For each of these business groups volume was up sequentially, and our plants were basically running at full capacity.

Our total commitment to our customers prevented us from taking advantage of opportunities with higher margin products in other markets; i.e., US and EMEA and we are now, however, moving ahead with a shift in production in concert with our customers to take advantage of these opportunities.

The Film and Electrolytic Group saw revenues increase from $30 million to $72 million with the addition of $42 million in sales from Arcotronics. We saw 46% of net sales going to distribution customers, 37% to OEMs, and 17% to EMS customers.

Tantalum and Ceramics, if we take them together, they did see small reductions across all sales channels. Unit volumes into distribution were up slightly in the quarter although the mix offset this to produce a slight decline in sales.

The Evox Rifa business continued to perform well, consistently beating our expectations and further strengthening our position in the OEM channel. Obviously, the addition of Arcotronics had an impact on these percentages. Overall, the Film and Electrolytic business group sold approximately 59% into the OEM channel, 32% into distribution, and only 9% into EMS customers.

Point of sale at our distribution partners moved slightly down in the December quarter, but inventory in the channel decreased by a similar amount. Turns at distributors are now in the range of 4 to 5 times and even higher in Asia.

Our book-to-bill for the quarter was 1.03 to 1 and we’re currently tracking at levels much higher than at the same point in the December quarter. Today, our book-to-bill is 1.25 to 1 compared to 1.08 to 1 at the same time the last Q, and our backlog is at its highest point since the year 2000.

By region, sales to customers in the Americas were 25% of sales, Asia 40%, and EMEA 35%. Again, the Film and Electrolytic business impacted these numbers due to its mix of 67% in Europe, 23% in Asia, and 10% in the Americas.

Our sales into Europe taken as a whole were up within the core business, driven in particular by strength in the OEM channel. Our lead-times have increased in the quarter, ranging from 6 to 10 weeks, but with a number of products extending beyond this range, and we’re working with our production facilities around the world to increase yield levels with particular emphasis on the high-demand parts across each of the business groups.

Our capacity utilization is over 90%, similar to levels reported elsewhere in the industry. As I noted, we are focusing our efforts on efficiency within our existing structure. We intend to meet higher volume requirements through ongoing lean manufacturing initiatives or we may very well and selectively add capacity in order to meet growing demand.

We’re seeing a mixed pricing environment with average selling prices on a mix adjusted basis down approximately 2% from the previous quarter. As I am sure you realize, the mix change I’m referencing does have a negative effect for us in lowering the revenue for parts sold.

Continued strong unit volumes within Asia together with a move to smaller case sizes put pressure on our margins in the quarter. We also have the usual seasonal softening of the industrial and military markets for leaded parts driven by the typical governmental budgeting cycles.

While pricing was not a positive factor for us during the quarter, we do not see a drastic change in the trend. We have had over the last quarters stable-to-slightly down ASPs.

Let me address what we’re now seeing from an end-market perspective. Computer business maintained its strength, continued high levels of notebook sales. The Consumer business remained strong during the December quarter but we did see that some of the ordering for the holiday builds came earlier this year and it came already in the September quarter.

Military markets were seasonally lower as I noted and the Medical business have experienced a temporary flattening related to performance of some products and end markets. Our Automotive business remained stable as electronic content per build grows even as build at the North American automakers seemed to slow.

Our European automotive business has remained strong and industrial markets have been stable as core economic conditions have remained healthy. However, obviously our customers are watching the current market indicators and what’s going on in the financial markets very carefully.

The communications market has been relatively flat, but we expect renewed strength here as infrastructure demands must eventually be met.

Our end market segmentation continues to shift as a result of the recent acquisitions, so I would like to update you on the new split. Communications 21%, computers 17%, industrial and lighting 28%, automotive 14%, consumer 11%, military 4%, medical 2%, and there remains other about 3%.

Moving down the income statement: gross margin percent decreased from 19.1% last quarter to 18.1% this quarter driven by, as I just said, unfavorable region and channel mix and the inclusion of nearly a full quarter of Arcotronics’ results. The Tantalum Group was able to maintain a gross margin of 19% despite lower sales while Ceramics saw a decrease in gross margin from 18% to 15%.

The Evox Rifa business enjoyed an increase in gross margin from 21% to 25% but the margin for the expanded Film and Electrolytic group was lower due to Arcotronics’ performance.

As you can expect, we are not satisfied with this performance and we are moving quickly to improve the situation. We must continue to calibrate our business to the operating levels needed to manage our business and continue to move quickly to achieve the synergy opportunities stemming from our recent acquisition.

Specifically, yesterday we announced a global reduction in force of approximately 385 employees. The annual savings from this action will be around $16 million, over $10 million in cost of goods sold and the remainder in operating expense. The associated severance cost of this introduction will be about $7 million and will be booked as a restructuring charge in the March quarter.

Furthermore, we announced last week the first major step in the integration of the Arcotronics business. Over the next five quarters we will move 420 jobs through our facilities in Kyustendil, Bulgaria, Batam, Indonesia, Matamoros, Mexico and Suzhou, China.

As a result, we’ll be able to close two plants in Europe this year. Once fully implemented, these actions will result in annualized savings of approximately $18 million. We are going to apply the same very simple principle: supply our customers in Asia with products produced in Asia. This process is just beginning and we will see increased activity in the coming two years.

To give you a heads-up on how this process will evolve, with the caveat of course that this is based on what we can see today.

Over the next couple three years, and in addition to the 420 jobs that I just spoke about, we will move an additional 250 jobs to Asia from Europe and cut an additional 300 jobs world-wide.

Given where we are today at 11,600 employees world-wide, the RIF of 385 jobs this week, a further 420 jobs this year as announced, 250 job cuts in two and years three moved to Asia and 300 cuts due to lean activities would give us an approximate 11,000 people in our workforce by fiscal 2011.

We find this sort of action very difficult. It is a necessary part of our business if we are to remain competitive in a very demanding global marketplace. It kind of is what it is.

The Arcotronics business has real opportunities for improvement and we are moving forward very quickly to address these. Sales effort is already integrated and the systems are right behind. Our ETBF order entry system, the Easy-To-Buy-From system is installed for the Evox Rifa business and will go live for Arcotronics in April.

Although some of this may not happen overnight since it does entail moving plants, et cetera, we remain excited about the upside that we see near-term for this business as we integrate it with the rest of our company.

As I just mentioned, we will close two plants in Europe, one in the UK and one in Italy this year. The good new is that we are able to move these activities to facilities we already own and we are busy preparing these facilities to welcome the Arcotronics business.

Operating expenses in the December quarter before special charges were $35 million, or 15% of sales compared to $28 million, or 14% of sales in the September quarter. This increase was driven primarily by additional Arcotronics SG&A of $6 million together with a slightly lower sales volume of flat parts in the quarter.

We continue to spend on R&D, approximately 4% of sales as we push to lead the way of new product introduction. We remain committed to operating expense levels of less than 15% going forward as we streamline our infrastructure and find additional synergies.

Our operating margin for the quarter dropped to 3% from 5% in the previous quarter and EBITDA was $21 million, or 9% before charges. On the bottom-line, our net income before special charges was $5.5 million which represent a decrease of $5 million from the prior quarter.

On a GAAP basis, net loss for the quarter was $6 million; special charges for the quarter totaled $6.5 million and were comprised of $1.8 million in non-cash write-down the facilities in Germany and South Carolina, $1.2 million for manufacturing relocations to existing facilities in Mexico and China, $1.7 million for reduction in force in Portugal and Germany and acquisition integration cost of $1.8 million.

In addition, income tax expense in the quarter included $5.2 million of one-time non-cash charges of $2 million related to Mexican tax law changes and $3.2 million related to asset disposal.

On the balance sheet, after adjusting for the purchase of Arcotronics and the pay-down of some of Arcotronics’ debt, we were able to generate cash during the quarter. Total cash and investment decreased by $25 million to $140 million and working capital was one use of cash excluding Arcotronics as we grew inventory by $12 million late in the quarter in response to a strong backlog.

CapEx was $12 million and depreciation expense $17 million. We expect fiscal ‘08 capital expenditures to be between $50 and $55 million, including approximately $7 million at the Film and Electrolytic facilities which should approximate depreciation and amortization expense for the year. Free cash flow in the quarter was $8 million.

Now, a quick update on our newest acquisitions. First, Evox Rifa. We are making great progress in this business now that we have a strong organizational structure in place. As is obvious from the results, we’ve been able to make positive changes to the business while welcoming Evox Rifa customers into the KEMET fold.

Many of those customers are now tied into the KEMET Easy-To-Buy-From system. We continue to make incremental changes to our manufacturing processes. Even though the Evox Rifa business was our best performing business in the quarter, there are still plenty of opportunities for further improvement to enhance performance. Evox Rifa did come in on our Timeless Model of 10% bottom-line and 25% gross margin.

Arcotronics: this business has a lot of room for improvement, but, so far, no surprises. The business performed as predicted in the quarter and we are working at an accelerated pace to get it further up to our standards. To do this, we are folding many of our detailed integration plants directly into those for Evox Rifa and pushing ahead with the process as a whole.

I’d like to give you a short summary of a few non-financial highlights for KEMET. First, during the quarter, we launched 33 new tantalum products, 16 of which were first to market. Ceramic introduced many, many parts and 83 of which were first to market.

In the Film and Electrolytics business, we introduced 156 new products 43 of which was first to market. For those of you who’ve been listening in on these calls for a while, you will notice these numbers are in some cases an order of magnitude improvement over just a few quarters back.

In order to better harness the brain power evidenced in these new products together with our Easy-To-Buy-From business model, we have also pushed recently to get our technical people out into the field more with our customers. With our recent acquisitions, our sales efforts needs to be more integrated with our customers’ design processes. We are working to expand that model across all dielectrics we provide.

Early returns are quite promising as we have seen examples of end products which would have taken a year or two to produce and get to our production facilities using our old model which we are now ready to supply to customers.

As you probably know, I spend a significant amount of time in the field with our customers and I can honestly say that the addition of the new businesses is opening up opportunities not only for the new Dielectrics, but also for the Tantalum and the Ceramic businesses. I am convinced that this new focus will pay off.

So, where are we now? KEMET is nearly a 1 billion capacitance company, sales and production around the world. We are able to provide all major dielectrics in the capacitor business, as the only company in the world I might add.

We source primarily from low-cost geographies and where we don’t, we are close to our customers. We are the Easy-To-Buy-From company. We are taking the lead on technical innovation in a number of product areas and we are working to ensure that we provide our customers value what we can best sell to.

We are bringing new tools to our newly-acquired businesses as quickly as possible and also learning from these new businesses and bringing these ideas to the Tantalum and Ceramic businesses.

As we succeed in these efforts, we will provide superior returns to our shareholders and raise the bar higher yet. As you might expect, we have for the time being closed our M&A activities. Our focus is to integrate what we’ve got. In a year-and-a-half, we’ve acquired three companies and our job is now to ensure that these business investments pay off.

In closing, we remain cautiously optimistic that demand will continue to move in a positive direction. That said, we and our customers are vigilant in watching the drivers of demand and we will react quickly to changes in the coming months and quarters of course.

I am excited about the opportunity for each of our three businesses and as always I want to thank our employees, our customers, suppliers, shareholders and the communities in which we work for all of their contribution.

And, that concludes my comments and we’d like now to open it up for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Matt Sheerin - Thomas Weisel.

Matt Sheerin - Thomas Weisel

My first question, just back to your summary of the quarter, when you gave guidance at the end of October, you talked about your core business being flattish and Arcotronics adding around $40 million or so, which happened. So, it looks like the core business was down 5 or 6% sequentially. So, could you be a little more specific about what happened in the quarter, the linearity, did things just kind of fall off in the month of December?

Per-Olof Loof

I tried to provide that in the comments, but let me just expand on that a little bit. And what happened in the quarter is that, if you go back all the way into the June-July timeframe, we saw orders coming down quite dramatically and we were able to secure businesses particularly in Asia in that quarter for delivery in the December quarter and we saw a lot of opportunity for these products to be sold in “more lucrative markets.”

But, we want to make sure that when we made a commitment that we stick with that commitment. And, therefore, we weren’t able to move products as quickly as we would have liked because the demand in Asia was so high. So, we were surprised by the demand in Asia and weren’t able to move these capabilities or these products to more “lucrative markets.”

Matt Sheerin - Thomas Weisel

So, is it fair to say that you may have lost some market share, some of those customers in the quarter?

Per-Olof Loof

I don’t think we lost any market share to some of the customers in Asia. What I said, we didn’t pick-up some market share in some other areas where we could have. So, we had a very strong order and we are working to try and ensure that we can deliver product to our customers.

We don’t actually give guidance, but the way you talked about that’s basically why we weren’t flat. We are predicting a flattish business for our core business and it didn’t come in quite flat.

Matt Sheerin - Thomas Weisel

Okay. Thanks for that explanation. And, then, you talked about very strong book-to-bill now. Are we to assume that you should be looking at a sequentially up quarter and could you be more specific about that?

Per-Olof Loof

With a caveat that the markets are probably more difficult to predict than ever. But, we are seeing very strong book-to-bill as I mentioned. You need to temper that just a little bit because the first week of January of course is a slow delivery month for obvious reasons, Christmas and the rest of it.

But, we are seeing a very, very strong demand. And, as I said, the backlog we have now is the biggest I have seen since I joined the company and I think it’s the biggest since the year 2000.

We are seeing very, very strong demand for our products across all geographies. And what we are doing from a practical matter, we are working with the large EMS customers in Asia, which is who we are working with in this case and ensuring that they can get parts from other partners and moving that production to areas where our products are better suited for our product activities.

So that’s ongoing and we will see that happening in the quarter. I wouldn’t be surprised if we saw in the Ceramic business a 5% shift in volume going from Asia to US and Americas in the quarter.

Matt Sheerin - Thomas Weisel

And then lastly, you talked about the restructuring and all of the benefits basically taking at least a couple of years or more. Could you give us any short-term margin goals that you have? I mean operating margins have declined for reasons that you stated, but could you give us an idea of where you would be targeting gross and operating margin over the next year?

Per-Olof Loof

We don’t give you that specific, but let me just talk about some of these reductions that we are talking about. The first reduction in force which happened yesterday and the people actually are gone as a result of yesterday. So that is affecting already this quarter, so the $16 million of cost reductions based on that, we will see to some degree affecting even this quarter and of course will be fully in effect starting in April.

The next tranche, which will be an $18 million reduction over the next year, will happen over the next fiscal. So by fiscal ‘09 that $18 million will be fully implemented. And then as I said we have another 250 to go over the next year or two after that, and then we should be, at least from what we can see now, having the facilities in the right places and we will be able to move our margins in a positive direction as a result.

Matt Sheerin - Thomas Weisel

And is that all coming out of cost of goods or is it some SG&A?

Per-Olof Loof

No, there is some SG&A involved. I mean the one we are doing now, there is $10 million coming out of cost of goods and $6 million and a bit coming out of SG&A − of the current one. That is really what we are seeing now. It is not the new businesses. I mean that’s really out of the old, the KEMET core business, that this is coming from.

Operator

Your next question comes from the line of Brian White - Jefferies.

Brian White - Jefferies

Just looking at the gross margin and operating margin, do we feel those have bottomed in the December quarter?

Per-Olof Loof

I bloody well hope so. Yes, I think they’ve bottomed out.

Brian White - Jefferies

Okay. So we should expect sequential improvement in the March quarter. What should we think about over a 12- to 18-month period in terms of a gross margin and an operating margin profile?

Per-Olof Loof

We’ve talked about our infamous or famous Timeless Model in the past and I should say that over the next two to three years that’s what we are in. And as you know we have now closed the M&A shop and now we are busy integrating these businesses and ensuring that we get all the synergies out of all of these opportunities and I think that over the next two to three years we will get to the Timeless Model as we have stated for now. So I guess it will be a timed model this time, not just Timeless.

Brian White - Jefferies

Okay. And when we think about the macro-environment, its impact on demand trends, what are you seeing? I mean, you talked about your book-to-bill here at 1.25; it might be influenced by some factors. But in general what are your customers saying and what are you seeing in terms of demand trends?

Per-Olof Loof

Most customer interactions that I have including a 6 o’clock phone call from one of our European OEMs this morning, is basically “get us parts.” So I mean the overall environment that we’re watching on the newsreels everyday and the financial markets and what we’re seeing there, has not yet affected what we see. However, clearly, if we are going to have a major slowdown eventually it will affect us as well, but so far we haven’t really seen it.

Brian White - Jefferies

So when we look at the 5% sales miss in the December quarter, that’s really attributed to having the proper footprint to provide for your customers?

Per-Olof Loof

We decided to make sure that we stayed with these huge EMS customers in Asia and made sure that we stuck with our commitments that we were basically out of capacity to go and take the opportunity that was elsewhere. And we just didn’t expect that demand to be that strong.

Operator

Your next question comes from the line of Shawn Harrison - Longbow Research.

Shawn Harrison - Longbow Research

A few points of clarification just on the $18 million in savings. Should we expect the break-out between COGS and SG&A to be similar in terms of where the savings fall?

Per-Olof Loof

I think you probably will see more of that in the COGS piece than you would see in the SG&A because in this case we’re talking about shifting jobs from high labor costs areas to low labor costs areas. So I would expect that the majority, not all of it, but the majority of it will be in the cost of goods sold.

Shawn Harrison - Longbow Research

And that $18 million, is that on top of the $3 to $6.5 million of savings that had been previously discussed in regards to Arcotronics?

Per-Olof Loof

Yes, this is on top of what we have seen in other areas as part of the SG&A. So, the SG&A synergies are ongoing as we said, but these are just in addition to what we have talked about it in the past. And we just announced this year what we are going to do and we want to be as transparent as possible with you all to ensure that you understand what we are trying to accomplish here.

Shawn Harrison - Longbow Research

And then two quick follow-ups. The 550 head count reductions over say the next two to three years, should we assume the savings per employee is similar to what you are seeing with the programs announced today?

Per-Olof Loof

The 300 will be spread across the board. And those are basically coming from lean initiatives and just basically improving our manufacturing processes and other lean activities across the offices as well. The 250, again that would complete the move of manufacturing activities in Europe to Asia.

Shawn Harrison - Longbow Research

But, so the savings per employee will vary?

Per-Olof Loof

It will the same that we are seeing. The 300 will be probably a little less than we saw with the 385 we did now because there is not that much more to cut in the US, and so these are coming out of other areas. So I think those cuts will be a little less than what you see now with the $16 million this time around. But the 250 is coming from Europe to Asia, and will be at the same rate. So if you want to have a number, I would say that’s $9 to $10 reduction in costs coming out of that activity.

Shawn Harrison - Longbow Research

And then finally, last summer you announced about $26 million in terms of restructuring savings that should have been in the numbers by the June quarter. Are all those savings in the numbers right now, and if so what served to offset those savings?

Per-Olof Loof

These are basically what we are seeing now. What we are announcing today has of course been in the works for quite some time, it just didn’t happen over the last couple weeks and we were ready with our plans relative to the Arco business and we are started in the discussions with the unions last week and have decided to make that information available to everyone of course. But those are the numbers, in addition to the $26 million.

Shawn Harrison - Longbow Research

Back in the June quarter of ‘07, you announced $16 million from head count reductions in Mexico, $4 million from the Tantalum business, $6 million from the Ceramic business, and they were all supposed to flow through on an annualized basis the P&L by this quarter. I was just wondering if those are in the numbers and what served to offset it, was it the negative mix shift, was it pricing, was it raw materials?

Per-Olof Loof

What offset the margin performance was a negative mix shift and also a negative market shift more to Asia and smaller parts.

Shawn Harrison - Longbow Research

So essentially those savings that were expected to roll on disappeared from the model and served to offset negative trends that you have seen?

Per-Olof Loof

They served to offset that and of course the actions we took have taken place.

Operator

Your next question comes from the line of Jim Suva - Citigroup.

Jim Suva - Citigroup

I don’t think I was clear as far as picking up, but normally you give at least directionally next quarter sales are up or down and I wasn’t able to exactly interpret what you were saying for next quarter.

Per-Olof Loof

Directionally, what we see now is that sales are up.

Jim Suva - Citigroup

And any way we can quantify that like 5%, 20%?

Per-Olof Loof

I wouldn’t go 20%.

Jim Suva - Citigroup

Okay 5%, 10%?

Per-Olof Loof

It’s hard to assess. As we see right now the sales are up relative to where we were in the October quarter. But if I were to put a number on this, I would say more in the 5%. Closer to 5% than to 20%, that’s for sure.

Jim Suva - Citigroup

Okay. And then can you help me understand the concern I have about book-to-bill very healthy, but your utilization is very high and I am wondering do you actually have the ability to get the product out?

Especially as we consider this quarter your inventory organically, if you strip out your acquisition, actually increased this quarter and you were saying that you had problems actually meeting some of the planned shifts in higher margin products and so inventory went up organically, you are not meeting your customer needs, book-to-bill and backlogs at all-time highs. I am wondering are you producing the wrong parts or how can you actually meet this demand with book-to-bill high and as well as utilization time?

Per-Olof Loof

The inventory is up that’s correct but that’s raw materials bought in the latter part of the quarter, so the finished goods inventories did not affect that. Having said that, we are able to increase our capabilities in particular in Ceramics by, I would say, sequentially a volume increase of 8 to 10% this quarter over last quarter through a number of initiatives, lean and otherwise, to improve our volumes.

And we are seeing volume improvements in the Tantalum business as well as we are putting some of the activities, through the [inaudible] business on the Arco side is coming on-stream and also further opportunities from lean initiatives.

So, we think that we could improve our volumes in the quarter and the volume increases that we think we can meet now and also having a healthier mix in terms of where these products go and what they are used for will improve our performance in the quarter from what we are seeing right now.

Jim Suva - Citigroup

My last question, just mathematically, can you just tell us what ASPs did for the quarter? You said flat for the last several quarters or flat to down 2%?

Per-Olof Loof

I said they were down 2%.

Operator

Your next question comes from the line of Steven Fox - Merrill Lynch.

Steven Fox - Merrill Lynch

Just on the book-to-bill, I was wondering if you could talk a little bit about the order trends on an apples-to-apples basis. Are you saying that your orders are improving or is this just a function of mathematics with the ratio?

Per-Olof Loof

No, no, no, the orders are improving.

Steven Fox - Merrill Lynch

By how much?

Per-Olof Loof

As I said, the backlog is at an all-time high and the orders are, this time of the quarter, they are up double-digit in terms of mix. Our order rate in this quarter is more than 10 million higher than it was in the last quarter.

Steven Fox - Merrill Lynch

And that is all on an apples-to-apples basis?

Per-Olof Loof

Forget the new business. In this case, we are just talking about the core business; we are not talking about Arco, we are not talking about Evox Rifa. We are just talking about the Tantalum and Ceramics.

Steven Fox - Merrill Lynch

Okay. And then just a bigger question Per, the stock has not done very well since you’ve taken over the company, you have done a number of acquisitions that have not yet produced the synergies that you’ve been promising; the margins are under pressure.

When you talk about improvements going forward, is there any internal metrics that you can point to that will give us confidence that the company’s actually on the right track and that now that you’ve done the acquisitions that you can bring this all together and turn it into a profitable organization again?

Per-Olof Loof

If you look at the acquisitions we’ve made, the Evox Rifa business is performing extremely well. I’m very confident that with the announced activities that we are taking relative to Arco, we are going to make that a good business as well in combining it with Evox Rifa. The business in Portugal is continuing to improve and we are basically producing more parts with 300 people less than during the past number of years. So, I think we are on the right track.

I can see how we are improving our yields in particular in the Ceramics area. And in this quarter, I really, honestly, attribute this to the issue we had with our Asian situation and the fact that we decided to stick with our commitment and thus weren’t able to take on service orders that we had or could have had in more higher margin countries.

When I took over the business, we had a $54,000 per employee business; today we are $87,000. And with these changes that were just announced, we will be at $100,000 per employee in a couple of years. So, that’s an internal metric, if you like.

Although this quarter was not a good quarter, margins have improved and I honestly believe that we have bottomed out in terms of that and unless something dramatic happens in the marketplace, I believe that we will see improvements quarterly in the March quarter and in the other quarters to come as we improve on all these shifts and changes in moving production to more cost-effective areas.

Steven Fox - Merrill Lynch

That’s really helpful and maybe in the future we can get some more details around internal metrics like that so that we could track the improvements a little bit better.

Per-Olof Loof

Absolutely.

Operator

Your next question comes from the line of Yuri Krapivin - Lehman Brothers.

Yuri Krapivin - Lehman Brothers

Per, you mentioned that Evox Rifa had gross margin of 25% and that Arcotronics had sales of $42 million, so I was hoping, you could give us the gross margins for Arcotronics and sales for Evox Rifa?

Per-Olof Loof

The Arco margins were 16% on sales of $42 million. That starts in the middle of October, so that is two and a half months of activities.

Yuri Krapivin - Lehman Brothers

And sales for Evox Rifa, do you have it?

Per-Olof Loof

It’s $31 million. Almost $31 million.

Yuri Krapivin - Lehman Brothers

And then, do you still track EPCOS on a stand-alone basis?

Per-Olof Loof

No, we don’t. That’s completely integrated into our Tantalum manufacturing processes now. There are two businesses there; there is the polymer business, which is completely integrated with our polymer activities in Asia and the MnO2 business is completely integrated with the activities in Matamoros and Victoria.

So, it’s impossible actually to relate it back to what happened with EPCOS. So having said that, our European business has improved and even on a sequential basis, Europe was up in the quarter.

Yuri Krapivin - Lehman Brothers

My second question is that KEMET has developed a strong relationship with Taiyo Yuden, and Taiyo Yuden has just recently signed a distribution agreement with Avnet in North America. Could that have any negative impact on KEMET?

Per-Olof Loof

We don’t think so and so. We keep meeting with and I keep meeting with [inaudible] every quarter and that relationship is fairly strong and is now over two years when we changed it to this more intense relationship. So, I don’t think that the Avnet is going to have a negative effect for us.

Yuri Krapivin - Lehman Brothers

And then, with respect to profitability, the focus on this call has been on unfavorable mix, but from other companies I am hearing about other profitability headwinds including currency, high material cost, high utility cost, rising labor cost in China, so on and so forth, maybe can you comment on overall cost inflation?

Per-Olof Loof

There is some increase in cost in those areas as you have noted, and of course the currency effect affects us to some degree and the fact that we are producing in Euro-land and selling into Dollar-land, is of course a negative for us. And that means that we need to move faster and moving activities from Europe to Asia even faster. So the Euro is clearly a negative for us; there’s no question as it is for most of the companies.

On the raw materials, we continue to believe that we can improve our material supply and keep them where they are or even decrease them to some degree and the fact that we have been able to move over to more base metals rather than precious metals of course has affected or will continue to affect our overall material cost situation. The issue with energy costs of course will hit us as well as everybody else.

Yuri Krapivin - Lehman Brothers

And, finally just to clarify, so essentially what you are saying is that after meeting your commitments to the Asian contract manufacturers and you took on those commitments back in the summer, now in the current March quarter you are dedicating more resources to North American and European customers and that’s why the mix should improve?

Per-Olof Loof

Exactly.

Operator

Your next question comes from the line of Andrew Huang - American Technology.

Andrew Huang - American Technology

So, first question on Arcotronics. You mentioned that the gross margin for that business was 16%?

Per-Olof Loof

Yes.

Andrew Huang - American Technology

Can you give me an idea of when or will that ever get to the corporate average, and if so when?

Per-Olof Loof

We expect that over the next year, as we are taking actions for that, we will see that margin improve, and we expect to see that starting early in the June quarter. And that’s a result of moving activities from high cost countries to lower cost countries, but also by improving the yields and improving pricing.

In the Arcotronics case we are able to see opportunities to actually increase our prices to some customers, so we’re doing that as well. Top-line improvement in prices again. So, we’re not seeing an ASP decline in that business. We’re actually seeing opportunities for some price increases.

Andrew Huang - American Technology

And would you expect the gross margin in that business to improve in the March quarter relative to December?

Per-Olof Loof

I think it will improve a little bit in the March quarter. The sales will be up a little bit but of course some of these things take a little while for it to flow through.

Andrew Huang - American Technology

And then, you did mention also I think that in the December quarter it contributed two and half months?

Per-Olof Loof

Right.

Andrew Huang - American Technology

So, therefore in the March quarter we should get the benefit of half a month? Correct?

Per-Olof Loof

Another half a month.

Andrew Huang - American Technology

The second question I have is related to operating expenses and if you look back historically, KEMET has been able to keep its operating expense dollars in the range of $18 million to $20 million a quarter and the beauty of that model is obviously that when demand got very strong and capacity got tight, then you would see a lot of earnings leverage. So, my question for you is with Arcotronics and Evox and EPCOS all under your belt, do you have a range of what that operating expenses dollar amount should be going forward?

Per-Olof Loof

We’re looking at a 14% model as a target going forward for operating expenses across the corporation.

Andrew Huang - American Technology

So, I guess that’s over the period of a cycle?

Per-Olof Loof

Right now we’re at 15% and we expect to be able to get to a 14% level actually, some of these activities are decreasing SG&A expense. As I said, out of the $16 million we talked about now $6 or $7 million is actually an SG&A reduction.

So clearly you got to cut expenses and we’re doing that but from a modeling perspective I think you should look at 14% as the target for operating expenses for KEMET.

Andrew Huang - American Technology

And you know, I think you mentioned an answer to one of the earlier questions, something about your sales per employee metric, but do you happen to have the operating income per employee handy?

Per-Olof Loof

No. The operating loss in fiscal ‘05 was significant, let’s put it that way. $10,000. And, now of course we have a different model. We have 11,600 people now and you can divide that with that. And in fiscal ‘05 we had 8,800 people and our operating loss was $50 million or so.

Andrew Huang - American Technology

Yes, okay. And then final question, you talked about the need to add capacity for certain products and I may have missed it, but did you give a capacity utilization number for the quarter?

Per-Olof Loof

Yes we did. We were over 90%. So, we’re about where everybody else has been. We still believe that a volume improvement or increase of 12% per annum is very reasonable. And, for us to be part of that, we need to ensure that we can, through yield improvements and other improvements, lean initiatives, get to that number, but also we see a need to extend selectively our capacity in some areas to be able to take advantage of these opportunities.

Andrew Huang - American Technology

Okay and then last question if you don’t mind. You are guiding the March quarter up sequentially, presumably the gross margins will improve sequentially, but the question is, how do you reconcile that with this seemingly very difficult macro environment we are under, and what’s your conviction level that those two metrics will improve sequentially?

Per-Olof Loof

What we’re seeing now is we’re seeing the order rate and we’re seeing the conversations we’re having with customers as we speak. Now we’ve already gone a month into the quarter so and we are higher on orders in the March quarter than we were in December quarter and also our sales are up relative to what they were in the prior quarter. So, the things that we see point to a sequential improvement.

Having said that, there are things that may happen, that may change things dramatically. God knows what’s going to happen to the stimulus package that’s been introduced, if that’s going to have a positive impact. Fed’s meeting as we speak, we don’t know what impact that’s going to have on how people view the macro situation.

We have the Beijing Olympics in August, which may have a positive impact. So, it is really very hard to read. So, I’m just giving you the data I have and then you are probably just as good to read the macro-environment, Andrew, than I am. So, I’ll leave it to you to try and figure this out. But what I can see at this point is a positive movement in our order rates and our sales rates and also in our mix rate.

Operator

Your next question comes from the line of Jim Suva - Citigroup.

Jim Suva - Citigroup

A quick follow up, on your restructuring, were those actions planned before the unsuccessful funding round that you went through?

Per-Olof Loof

Yes, in terms of the overall magnitude of them, we had them planned yes.

Jim Suva - Citigroup

Okay. So it’s fair to say that they are two completely independent activities.

Per-Olof Loof

They are two completely independent activities, yes.

Operator

There are no further questions at this time, are there any closing remarks?

Per-Olof Loof

We appreciate you being with us this morning and this was a disappointing quarter no question, but from what we can see we are taking the necessary steps to cut the costs, we’re taking steps to ensure that the integration of the new companies goes swiftly, and over the long term, I have a very positive view of what the company can do, and I’m seeing customers responding to the capacitance company across the board. So, thank you very much and you all have a good day.

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Source: KEMET F3Q08 (Qtr End 12/31/07) Earnings Call Transcript

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