2023-08-09 16:30:50 ET
Summary
- Key Tronic is an electronics contract manufacturer whose revenues have grown by over 80% since FY14.
- The company seems cheap at first glance as it’s trading at less than 0.5x P/BV and below 13x P/E.
- However, debt has been rising due to the low margins and the lack of free cash flow and stood at $123 million as of April 1.
- With interest rates on the company’s debt ranging from 4.85% to 7.92%, I think that funding growth with more borrowings is a recipe for disaster.
Introduction
As I’ve mentioned in several of my recent articles on SA, I’ve been on the lookout for small-cap companies with growing revenues to add to my portfolio. Among the stocks that popped on my radar is Key Tronic (KTCC), an electronics contract manufacturer with a TTM P/E ratio of 12.8x as of the time of writing that has grown its revenues by just over 80% since FY14. The book value per share is over $12 but this is a business with razor-thin margins and the lack of decent free cash flow over the past several years meant that increasing working capital needs due to growth have led to a rising debt load. This wasn’t a major issue when interest rates were low, but I think that the company is starting to struggle now and my rating on the stock is neutral. Let’s review.
Overview of the business and financials
Key Tronic was founded in 1969 and was initially focused on the production of computer keyboards. Today, the company is a contract manufacturer specializing in "PCB assembly, plastic molding, and full product assembly" and its products include all kinds of electronics and appliances "ranging from simple consumer devices to complex, high-end commercial and industrial electromechanical products". Key Tronic has manufacturing facilities across the USA, Mexico, China, and Vietnam and its revenues surpassed the $500 million mark in FY21. The company is a minor player in the highly competitive electronics contract manufacturing industry with a global market share of less than 1% (see page 5 here ) and this is why its focus is on accounts with low to medium volumes with high flexibility requirements.
Looking at the financial performance of Key Tronic for the past several years, we can see that revenues have slowly grown from $305.4 million in FY14 to $551.7 million for the 12 months ended April 1, 2023. Since FY14, the compound annual growth rate of revenues has been 6.99% but it seems that there are no economies from scale here as the operating income remains below FY16 levels.
This is a cutthroat business with low barriers to entry which leads to low margins and as revenues grew and working capital needs increased, Key Tronic has relied on an increasing debt load to fund its expansion over the past years as free cash flow has seldom been positive. Looking at the net margin, it has rarely surpassed the 1% level over the past decade.
This wasn’t a large problem during the zero interest rate policy (ZIRP) era, but with central banks around the world rapidly rising interest rates since early 2022, Key Tronic’s financials are now coming under serious pressure with normalized diluted earnings per share dropping from $0.33 in FY21 to just $0.10 for the 12 months ended April 1, 2023.
Looking at the financial results for the first nine months of FY23, we can see that interest expenses soared by 94.4% year on year to $7.08 million as total debt rose to $123 million from $108.2 million a year earlier while the interest rates on outstanding debt ranged from 4.85% to 7.92% on April 1, 2023 (see page 10 here ), compared to a range from 3.25% to 5.52% on April 2, 2022 (see page 10 here ).
While operating income improved by $5.57 million thanks to net sales growth, it’s worth noting that Key Tronic recorded a $4.04 million gain from insurance recoveries mainly related to a lightning strike that damaged its Arkansas facility in July 2022 (see page 13 here). Without the gain from these insurance recoveries, pre-tax income would barely be above $1 million.
Looking at the cash flow statement, total cash used in operating activities for the first nine months of FY23 came in at $17.1 million as working capital needs increased due to growing sales. CAPEX, in turn, came in at $4.87 million (see page 6 here). In my view, the free cash flow and debt situation is unlikely to improve anytime soon as Key Tronic mentioned in its Q3 FY23 financial report that its sales were constrained by global supply chain issues (see page 18 here). This means that revenues and working capital needs are likely to keep expanding over the coming years. The company said during its Q3 FY23 earnings call that revenues for Q3 FY23 are expected to range from $150 million to $160 million, which means that FY23 revenues could top $585 million or some 10% higher than FY22. The Q4 FY23 financial results are likely to be released around the middle of September.
Overall, I think that Key Tronic looks relatively cheap at first glance as the book value per share is $12.03 while the P/E ratio based on the results for the 12 months ended April 1, 2023, is 12.8x. However, I think that the company is digging itself into a hole as interest expenses are increasing much faster than operating income as a result of the low margins of the business. I think that the two most likely solutions for this issue in the coming years include a capital increase or a debt restructuring. In my view, Key Tronic is becoming a value trap.
Investor takeaway
Key Tronic has generated decent revenue growth over the past several years and the company is valued at below 0.5x book value as of the time of writing. However, the economies of scale seem to be inconsequential as the operating income margin has remained below 2%. With interest rates on the company’s debt ranging from 4.85% to 7.92%, I think that funding growth with more borrowings is a recipe for disaster and that normalized diluted EPS are likely to fall further during the coming years. In my view, it could be best for risk-averse investors to avoid this stock.
For further details see:
Key Tronic: Debt-Fueled Growth And Low Margins Don't Mix Well