Charge up your fixed income portfolio returns with high yield bonds from KEMET, an electronic component solutions company. Each week we screen thousands of corporate bond listings to find what we believe to currently be the best corporate bond for investors needing or seeking higher yields with the least amount of risk as possible relative to its projected return. The following is our review process that shows why we believe these B2/B+ rated US corporate bonds, with greater than 10% yields and under six year maturity (with a possible call in less than 4 years), passes the criteria for our clients, and why we have selected them for addition to other high yielding corporate bonds in their investment portfolios.
Step 1 - Assessing the Yield Curve
The higher yields fixed income market continues to be driven by money inflows, and remains resilient despite stock market action. Along with declining fixed income yields are heightened concerns for acquiring fixed income instruments that can outpace inflation without adding excessive risks. With the 5 years treasuries currently trading near a record low 0.60 % yield and the (possibly flawed) CPI at 2.8%, this comparable term 10% bond might has the possibility of making a remarkable improvement in wealth preservation as long the underlying fundamentals of the issuer, which we will review the major elements of here in this article, remain sound.
Step 2 - A look at the issuer
KEMET Laboratories was founded by Union Carbide in 1919, and KEMET Corporation (KEM) became a US listed company in 1992. Headquartered in Simpsonville, SC and employing about 9,600 people worldwide, KEMET has 22 manufacturing facilities (15 owned, 7 leased) in Mexico, China, Indonesia, Europe, and the United States. KEMET's extensive network of global distribution partners serve a customer base that includes nearly all of the world's major electronics original equipment manufacturers (including Alcatel-Lucent (ALU), Apple (AAPL), Bosch, Cisco Systems (CSCO), Continental AG (CTTAY), Dell (DELL), Hewlett-Packard (HPQ), IBM (IBM), Intel (INTC), Motorola (MSI), Nokia (NOK), and TRW (TRW)), electronics manufacturing services providers (including Celestica (CLS), Flextronics International (FLEX), Jabil Circuit (JBL), Sanmina-SCI (SANM) and distributors (including TTI (TTI), Arrow Electronics (ARW) and Avnet (AVT)).
KEMET is a global manufacturer of tantalum, ceramic, film, aluminum, electrolytic & paper capacitors. Capacitors are passive electronic components that store, filter, and regulate electrical energy. 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 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.
KEMET operates in three distinct businesses: Tantalum, Ceramic and Film & Electrolytic. Ranked #1 in the $1.9 billion global Tantalum capacitor market with about 26% of market share, they also have about 3% of the $8.0 billion Ceramic and about 4% of the $9.8 billion Film and Electrolytic capacitor markets. In recent years, KEMET has put more focus on growing market share in the specialty markets, including: alternative energy, extreme environments, medical, and military/aerospace. Specialty products represent higher margin business which generally require longer product design cycles, but also benefit from longer product lifecycles and greater servicing needs. For fiscal years 2012 and 2011, consolidated net sales were $984.8 million and $1,018.5 million, respectively.
Because 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, though cyclical, continues to grow. According to a March 2012 report by Paumanok Publications, Inc., a market research firm concentrating on the passive components industry, the global capacitor market in fiscal year 2012 (ending March 2012) was forecast to be $17.9 billion in revenues and 1.6 trillion units, down from $19.4 billion in revenues and 1.7 trillion units in fiscal year 2011. According to the Paumanok report the global capacitor market is expected to improve substantially and achieve revenue and unit sales volume of $24.4 billion and 2.4 trillion units, respectively in fiscal year 2017. This would represent revenue and unit volume increases of 36% and 51%, respectively, from fiscal year 2012 to fiscal year 2017.
In fiscal year 2012, KEMET acquired Cornell Dubilier Foil, LLC (whose name was subsequently changed to KEMET Foil Manufacturing, LLC) and Niotan Incorporated (whose name was subsequently changed to KEMET Blue Powder Corporation), allow them to achieve some vertical integration. In addition, on March 12, 2012, KEMET entered into a Stock Purchase Agreement to acquire 51% of the common stock of NEC TOKIN Corporation (NT), a manufacturer of tantalum capacitors, electro-magnetic, electro-mechanical and access devices, from NEC Corporation (NIPNF) of Japan. Along with this, KEMET also holds the option to purchase all outstanding capital stock of NT from its stockholders (primarily NEC Corporation) by May 31, 2018, the details of which are revealed in its most recent SEC filing.
Step 3 - We like companies that are profitable
In fiscal year 2010, KEMET initiated the first phase of a plan to restructure its Film and Electrolytic business and to reduce overhead within the company as a whole. This included removing excess capacity, moving production to lower cost locations and eliminating unnecessary costs. Restructuring charges in the fiscal year ended March 31, 2012 relate to this plan and primarily comprised of termination benefits of $6.1 million related to facility closures in Italy that will commence during fiscal year 2013 and charges of $4.5 million to participate in a plan to save labor costs. Construction has commenced on a new manufacturing facility in Pontecchio, Italy, that will allow for the closure and consolidation of three manufacturing operations located in Italy. As the three existing facilities in Italy are vacated, the properties will be offered for sale.
During the remainder of their restructuring effort, KEMET expects to incur charges of $25 million for relocation, severance and other restructuring related costs in Film and Electrolytic. In addition, they expect to incur $36 million of costs primarily related to the purchase of land and capital spending related to the construction of two new manufacturing locations, including the aforementioned new facility in Italy. These efforts should result in a $5.7 million reduction in their operating cost structure in Europe in fiscal year 2013 compared to fiscal year 2012, with benefits continue to grow during fiscal years 2014 and 2015. During fiscal year 2015, they expect to achieve total annualized operational cost reductions of $25 million to $30 million versus fiscal year 2012.
Net Sales for the year ending March 2012 were $984.8 million, a decrease of 3.3% over the prior year's period, while net income was reported at $6.7 million compared to $63.0 million. Gross margin for the fiscal year ended March 31, 2012 decreased to 21.2% of net sales from 26.1% of net sales in the prior fiscal year, primarily due to the gross margin decrease of $61.4 million relating to the inability to pass raw material cost increases of Tantalum on to our customers. Average selling prices in the Tantalum division increased 23.1% in fiscal year 2012 as compared to fiscal year 2011, but unit sales volume for fiscal year 2012 decreased 30.4%. In addition, KEMET Blue Powder contributed an operating loss of $1.7 million as it has been running well below capacity. However, Blue Powder is planned to be running near capacity at the end of the first quarter of fiscal year 2013.
Step 4 - Interest Coverage Ratios
Finance expenses were reported at $28.6 million, while operating income was $37.8 million. Although at first this may not look like good coverage, it is worth noting that operating income includes a $14.3 million restructuring charge and a $15.8 write down on long-lived assets. Excluding loss charges, income coverage appears well over 2x's interest expenses. Furthermore, using 2012's adjusted EBITDA of $128.3 million indicate a much stronger 4.5x's coverage. While financing costs are expected to increase to $35.9 million next year due to the added debt in March 2012, we also expect income to increase and restructuring charges to decrease. Therefore we view KEMET's overall ability to make its interest payments as being quite strong.
Step 5 - We like companies with lower debt to cash ratio
In March of 2012, KEMET completed an additional $110 million in senior notes, and cash and cash equivalents totaled $ 210.5 million as of March 31, 2012. Total debt appears to be at $347.3 million, giving a very good debt to cash ratio of about 1.65 to 1. However, this ratio may increase as larger capital expenditures relating to acquisitions and restructuring progress.
Step 6 - We like companies that have flexible balance sheets
KEMET's debt of $347.3 million is slightly less than its currently indicated enterprise value. Recent depreciation and amortization expenses were given as $44.1 million, leaving property, plant and equipment assets showing at $315.8 million, which we think quite likely to be undervalued relative to their actual cash value. Overall, we consider KEMET to have adequate balance sheet flexibility.
Step 7 - We like higher yields
This US dollar denominated bond issued by KEMET has a face coupon of 10.5 and is trading at a slight premium, currently indicating a 10.1% yield to worst call at par in May of 2016. Otherwise, its yield to maturity in May 2018 is 10.21%. In contrast, three year U.S. Treasuries are only yielding a paltry 0.34%. Although the credit ratings are widely different, we believe this nearly than 9% difference in yields is incredibly high given the level of risks that we can identify.
Step 8 - Risks Considerations
KEMET is in still the process of restructuring, which includes integrating recent and new acquisitions. The projected cost savings of mergers can often prove be elusive, and it is early in the process to say what extent or degree of success management may have in implementing these plans.
The market for capacitors is highly competitive, and the capacitor industry is characterized by, among other factors, a long-term trend toward lower prices, low transportation costs, and few import barriers. It is also noted as being a cyclical business, impacted by global economic events or considerations. Competitive factors that influence the market for these products include product quality, customer service, technical innovation, pricing, and timely delivery. We think that KEMET competes favorably on the basis of these factors, and view their restructuring efforts as adequate to maintain and/or possibly increase their current capacitor market share or current profit margins.
We believe that these KEMET Corporation bonds have similar risks, similar maturities, or similar yields to the Tutor Perini (TPC), Georgian Railway, Seagate Technologies (STX), or Netflix bonds (NFLX) reviewed previously on our Bond-Yields.com blog.
Summary and Conclusion
This is an exceptional yield, especially considering its medium term 6 year maturity and strong possibility of being called two years earlier. Although KEMET bonds are rated as B2/B+, we believe they are an intelligent risk opportunity offering a significantly higher yield from a company that has a solid business, a good cash position, sound interest coverage, and a flexible balance sheet.
Ratings: B2/ B+
Yield to Maturity: 10.21 %
Yield to Worst: 10.097 % (call at par, 5/01/2016)
Please note that all yield and price indications are shown from the time of our research. Our write ups are never an offer to buy or sell any security. We are not a broker/dealer, and reports are initially written for our clients. As a result of our institutional association and fiduciary duties, we frequently obtain better yield/price executions for our clients than is initially indicated in our research.
Disclosure: Durig Capital and certain clients may have a position in KEMET Corporate bonds.