KME – new position on the bonds following the Q2 20 results call
All,
Please find our updated analysis on KME here.
We are buying the KME bonds for 3% of NAV at around 71 (YTM25.6%). We estimate that the bonds could return to the mid-high 80s as the business returns to its previous levels, in line with the overall European Manufacturing PMIs, while cash flow conversion of EBITDA retains its significant recent improvement. We would expect this to become clearer in the next 6 months.
Based on the trading levels during the lows of the pandemic, we would not expect the bonds to dip below 50. In the current less stressed market environment, we see downside protection in the low 60s for the bonds, based on the hard collateral behind them, namely the Osnabruck plant, which has been recently reappraised up by EUR12m. However, additional potential costs related to financial distress could see the bonds dropping below the collateral level, into the mid-50s.
We have also seen two key parts of KME's cash flow story moving in the right direction. Once adjusted for non-cash variations of inventory value due to price fluctuations (mostly copper), we estimate a meaningful improvement on one-off cash flows, which would be consistent with the completion of the heavier portion of the synergy and integration/disposal efforts of MKM on one side and Brass on the other. In addition, we see a major decline in Capex, back to the levels before the 2018/2019 ramp up, which raised concerns of potential cost capitalization among investors.
In an environment where European manufacturing PMIs have returned to yoy growth, we see KME, with its diversified end demand profile, as a good recovery play in an environment where the goods-producing part of the economy is clearly diverging from services.
We estimate that EV/EBITDA multiples for this business should be north of 8x, in line with other industrial segments with decent structural fundamentals and differentiation, such as specialty chemicals (Nouryon, Perstorp...). This is in line with the structural factors discussed in our analysis.
Because of KME's headroom under the asset-backed facilities, and to a less extent the shareholder-provided credit line, we see little risk of a liquidity crunch, and indeed the company is currently considering bond buybacks.
Please feel free to reach out if you would like to exchange ideas on the name.
Juliano
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