Key Tronic is profitable and growing, but its price is below its book value (NASDAQ:KTCC)

Source: keytronic.com

I wrote about Key Tronic Corporation (KTCC) about a year ago in this article. At that time, the stock was trading at $5.70 and my one-year price target was $12. With the stock currently trading at $8.00, it is up 40% but has not reached my target. The company released its results yesterday. While they were good, the conference call revealed a much stronger company masked by Covid-19. This article explains why Key Tronic is in a better position than a year ago with an increase in revenue and profit. Once Covid wears off, Key Tronic’s true strength should be revealed.

My investing mantra is that the upside potential must far outweigh the downside risk. Key Tronic’s decline is protected by a strong balance sheet. It trades just above working capital minus long-term debt. The stock price is also lower than the tangible net worth. Additionally, the company, although underperforming, is seeing an acceleration in earnings and revenue. It has several catalysts to further increase revenue. These enablers and forces will be discussed below.

context

Key Tronic is an electronics manufacturing services (EMS) company based in Spokane Valley, Washington. She turned 51 this year and started making keyboards. Today, almost all of its revenue comes from contract manufacturing for other companies. It designs and manufactures electronic products, and is also involved in mechanical engineering, sheet metal fabrication and stamping, and plastics. It has factories in Mexico, the United States, China and Vietnam. As of June 27, 2020, plant area by region was; United States 43%, Mexico 43%, China 7% and Vietnam 7%. Key Tronic’s sweet spot is the products of customers with annual revenues of $5-50 million per year.

finance

Key Tronic, although mostly profitable, has underperformed in recent years. Revenues have remained stable for many years. The financial results for the last four years and the last two quarters are presented below.

Source: Value Line and SEC filings

As noted above, revenue and earnings have improved significantly over the past two quarters. Even so, they were masked by Covid costs primarily at the Mexican site due to labor issues, high shipping costs from Asia and supply disruptions. Adjusted for Covid costs, EPS has risen significantly to $0.26 and $0.27 over the past two quarters. Management on the conference call said that without the Covid disruptions, revenue would be around $150 million per quarter due to several new contract ramp-ups. This is a 34% increase over the previous year. In addition to the $150 million run rate, Key Tronic has a handshake deal on a new $100 million a year contract. Management also noted that Mexico’s Covid issues are receding as the city of Juarez recovers rapidly.

Management has forecast revenue of $130 million to $140 million this quarter with earnings per share of $0.20 to $0.25. It looks like there is still some Covid impact in these numbers, but less than last quarter.

Forces and enablers

Key Tronic now has significant strengths and catalysts to boost profits in the future.

1. Balance sheet – Key Tronic has a strong balance sheet that can be immediately used for acquisitions, growth investments, share buybacks or dividends. As of December 26, 2020, she had a tangible net worth of $123 million and working capital of $174 million. In fact, working capital, even after deducting long-term liabilities, was still $74 million. That’s close to the current market cap of $87 million. The company does not currently pay dividends or buy back shares. Its priority is acquisitions and debt repayment.

2. Scale – In the last conference call, management said there were not many new fixed costs needed to grow revenue from $128 million per quarter to $150 million. This means that profits will grow faster than revenues. Moreover, the new Vietnamese plant is now sufficiently ramped up and should no longer weigh on results.

3. Acquisitions – Acquisitions are very affordable in this industry as shown by lower PE ratios for listed peers. Smaller companies generally have lower PE ratios than larger ones. The industry is fragmented and there are many applicants. Key Tronic has the track record to make significant acquisitions and has done so on a limited basis in the past.

4. Price to book – On December 26, 2020, price to tangible equity was 0.71x and price to working capital less interest-bearing debt was 1.18x. There are very few profitable growing companies that trade well below their tangible book value. The only other I can think of is RELL which I also own. The strong balance sheet and low price offer investors significant downside protection.

5. Market position – This is perhaps the best reason to invest in Key Tronic. It is perfectly positioned to take advantage of the trade war with China and the move towards outsourcing. It has a large and growing operation in Mexico and the new factory in Vietnam is now ramping up. These two countries are the top two choices for companies moving manufacturing from China. The company just added about 100,000 square feet of capacity in Mexico. Even if the trade war with China subsides, fear of another war will push manufacturing that once went there to Mexico and Vietnam. In addition, wages are increasing in China. Mexico and Vietnam are the new China.

6. Channeling — Management has a handshake deal on a new $100 million revenue deal. It would be one of their two biggest accounts. Partly due to the trade war and the doubling of the number of sales reps in 2019, the new business pipeline is currently very high. The trade war and the increase in the number of sales representatives are two major tailwinds for the future.

7. Redemption Bait – Key Tronic’s geographic positioning, its expertise in its industry and its low cost price make it a target for acquisition. Management does not have enough shares to block one.

8. Dividend or redemption of shares – Key Tronic does not currently engage in dividends or share buybacks. They have the track record to do so and improving earnings will make one or both more likely. An announcement on either should help the stock.

Concerns

Key Tronic has a long missing guiding experience, dating back 6 years. Previously, under the same CEO, it consistently met or exceeded guidelines.

Management owns less than 5% of the shares.

Customer concentrations have been a problem in the past, as a lot of their struggles have been with their biggest customers losing business. In fiscal 6/20, the top five customers accounted for 40% of revenue. This figure is down from 62% before the Ayrshire acquisition in 2014 and 42% in FY6/18. Currently, a single customer is over 10% to 18%. The new $100 million contract, if consummated, would have a similar focus.

The EMS industry in general is growing steadily but has low profit margins. Most publicly traded EMS companies trade at lower PE ratios than the market average. I think this is due to low margins, cyclicality and volatility in earnings.

Perhaps not a negative point, but the 12 million dollars of Capex expected for this exercise are relatively heavy. This is necessary to support the expected growth.

Evaluation

Key Tronic earned $0.14 last quarter, a quarter that was depressed by Covid-19-related costs totaling $0.13 per share.

Key Tronic is compared to other listed EMS manufacturers below.

Source: Value Line and Forms 10-K

Key Tronic currently has a lower PE ratio than the industry average and a significantly lower selling price. Still, it has below-average leverage and above-average revenue growth. Looking at the two similarly sized peers, it has a similar sale price to Nortech (NASDAQ: NSYS) despite much lower leverage and better earnings. It also has a much lower selling price than SMTC (SMTX) despite much better revenue and leverage. SMTC is experiencing better growth and is under acquisition contract.

Key Tronic has earned $0.53 adjusted for Covid over the past two quarters. Annualized is $1.06 EPS. I believe with scale benefits they can earn $0.32 per quarter once Covid passes. To be conservative, I’ll use the figure of $1.06. The industry average PE ratio is 15. Key Tronic is actually growing faster than its peers, which are growing 0-5% per year. Key Tronic also has less leverage. The downside is that Key Tronic is smaller than most peers. Again, to be on the safe side, the peer PE ratio of 15 is used. This translates to a one-year price target of $16.00.

Carry

Over the past five years or more, management has always found an excuse to justify underperformance in every quarter. While still the case, revenue and earnings (GAAP and adjusted) are growing and seem to be accelerating. The problems of the past seem to have disappeared and Covid should disappear in the spring. I recommend a long position in Key Tronic.

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