Key Tronic Corp. is an electronics manufacturing services (EMS) provider that churns out custom parts and components by the millions. Key Tronic’s capabilities include design, manufacturing, supply chain and logistics functions through its locations in the US, Mexico and China. Key Tronic got its start as a manufacturer of keyboards, but abandoned that business in favor of serving as a supplier to the computer, automotive, medical industrial and military industries, among many others.
Key Tronic is capable of producing a staggering array of custom products through its advanced equipment and processes. A few examples from the company’s site:
A projector.
A blood sugar testing kit.
Haven’t a clue.
As of June 30, the company was manufacturing products under 186 programs for 56 customers. Unfortunately, the majority of Key Tronic’s revenues are attributable to a small number of clients. In fiscal 2013, five customers accounted for 71% of sales. What’s more, the EMS industry is intensely competitive and margins are low. Gross margins for the trailing ten fiscal years averaged just 8.63%. Operating margins averaged just 3.03%.
If I haven’t scared you off yet, there is also a lot to like about Key Tronic. Despite operating in a challenging industry, the company has an impressive history of revenue and earnings growth. From fiscal 2003 to fiscal 2013, revenues rose at an annual rate of 10.7% and operating earnings grew at 21.4%. ROE averaged 14.3% and book value per share compounded at 13.7%. Recent results show rising margins. In fiscal 2013, Key Tronic achieved an operating margin north of 5% for the first time in at least a decade.
Historical free cash flow looks bad, but this is often the case with consistently growing companies. Increased revenues require additional investment in working capital, which depresses operating cash flow. The absence of free cash flow is not a concern, so long as investment in working capital continues to be profitable and the company’s ROE remains strong.
Key Tronic’s balance sheet is the healthiest it has been in a decade. The company used its strong 2013 free cash flow to pay off all debt and build a healthy cash cushion. The company’s current ratio and equity-to-assets ratio are the healthiest they have been at any point in the last decade.
Subsequent to quarter’s end, Key Tronic purchased Sabre Manufacturing for $5.1 million in cash. Sabre is a metal fabricator located near to Key Tronic’s Juarez, Mexico plant. The company notes the acquisition will enable it to expand its service offerings to clients and will be immediately accretive to earnings.Key Tronic’s facilities in Mexico are valuable strategic assets as cost inflation makes Chinese manufacturing less competitive than it once was. Mexico’s proximity to US consumers and low energy costs combine to make Mexico a more attractive manufacturing location day by day.
For all Key Tronic’s historical success, the market is taking a dim view of the company’s prospects. Shares are off 18% from the yearly high set just two months ago. Perhaps the market is right, and advances in technology and changing consumer tastes will halt Key Tronic’s growth and hurt profitability. The PC industry is in the doldrums and 3D printing threatens to usher in a small-scale manufacturing boom. However, PC components are only one of Key Tronic’s many business lines, and the company has years to replace any lost revenue. PC sales have been in decline for some time now, yet last year’s revenues were a new record for Key Tronic. And while 3D printing will continue to advance, the technology is still a very long way from large-scale commercial viability and an even longer way from competing with high volume producers like Key Tronic. The market is discounting very long-term nebulous trends as if they were imminent threats to Key Tronic. Also, the market is completely ignoring the company’s recent balance sheet transition and the company’s excess cash position. Here are figures based on today’s closing price and ignoring the Sabre transaction.
Key Tronic looks cheap, particularly on an EV/EBIT basis. Healthy, growing firms with zero debt do not routinely trade at a 5.5x multiple. I don’t know what will change the market’s mind, but I suspect it will change. Key Tronic does not deserve such a meager multiple and I expect the current depressed valuation will not last.
No position.
Nice post. This is exactly the type of easy to understand company to build up a fairly position in when it’s for no reason (as in 2012) is priced less than BV. Without taking to much risk. At this Price it’s a bargain in terms of what you pay for the ebitda and ebit, but with the inherent risk of few customers accounting for the majority of the revenues and less efficient cash management (its able to generate quite decent FCF during growth even if it’s substantially harder for a manufacturing company) I would be comfortable to buy it at a bargain Price to BV as well. With a ROE about 14%, PBV </= 1.00.
/John, Sweden
Thanks for the post! I really like that this company is easy to understand and not ridiculously illiquid! (like some of the other companies you cover here).
Regarding the risks, I’ll take a look but if the bear case solely consists of PC industry dying and the overblown hype of 3D printers, then this may actually be pretty attractive. Kinda reminds me of Seagate (STX) and Western Digital (WDC) circa 2010 and 2011. Everyone thought SSD were going to kill HDD even though the former was exponentially more expensive and not viable to be used in the “cloud” servers.
I’m just afraid of the macro factors and was wondering if you could comment on them. I know this company’s got no debt so rising interest rate won’t damage the bottom line but will P/E compress if rates move up in 2-3 years?
Thanks & cheers…
I agree that the market is discounting vague, distant future threats to Key Tronic’s business model as if they were going to happen overnight. Whenever that happens it spells opportunity for investors.
I wish I could comment on the macro factors, but I am afraid I simply don’t pay a lot of attention to them. Rising rates would likely hurt the performance of all equities in the short run as fixed income products become more attractive. However, higher rates would likely improve equity returns for the long run. If the equity risk premium is 4%, I’d rather the 10 year treasury rate be 4% than 2%, assuming inflation is unchanged. In general, a rise in real interest rates would be healthy for equities in the long run, but any increase does not seem likely for now.
Can you comment on why a rise in real interest rates would be healthy for equities in the long run?
Sure. The long-term real return on equities (as an asset class) is equal to the real risk free rate plus the equity risk premium.
For example, if the risk free rate is 4% and inflation is 1%, the real risk free rate is 3%. Assuming the equity risk premium is 3%, the long-term real rate of return on equities is the real risk free rate plus the equity risk premium, or 6% in this case. If the real risk free rate moves up to 5% and the equity risk premium does not change, the long-term real rate of return on equities increases to 8%.
If the real risk free rate increased, the short-term effect on equities would be negative, as future cash flows are discounted at a higher rate. However, the long-term returns would increase.