(Debtwire) KME orders dip but Intek warrants, entity separation and synergies support bull case

21 October 2020 | 12:01 BST

KME’s 3Q20 new order intakes were down around 10%-17% while adjusted leverage is in double-digit territory when including letter of credit usage and its pension deficit. But the Germany-headquartered copper alloy group reduced capex helping cash generation, a separation of legal entities could mean disposal opportunities, increased synergies can boost earnings while shareholder Intek's EUR 115m warrant issue provides extra potential firepower. That makes its EUR 300m 6.75% senior secured 2023s yielding 22.7% pretty attractive for two buysiders, with a third buysider cautious.

The company recently reported 2Q20 results and held an earnings call last Friday (16 October). LTM 2Q20 adjusted EBITDA was resilient, inching up to EUR 88m from EUR 87m at FY19 and close to EUR 90m for the LTM 1Q20 period, as KME remained relatively immune from COVID.

The outlook in its Special division was positive with management noting the steel segment is bottoming out while there was a stable environment in its maritime defence business with COVID not impacting the business and no negative developments going into 2020.

Management also noted that order books were developing well in the Copper division, and plants have had a fast recovery of volumes. KME was impacted by the 2Q20 auto slowdown, but orders still continued and inventories are in balance again while margins remain stable.

"KME is sometimes compared to [German copper producer] Aurubis but it has a different profile as they are removed from the commoditized part of the copper value chain in both the Special and the main copper division," special opportunities firm Sarria said. "On Special they have a strong level of differentiation and even with Covid the business was resilient. On the copper product the differential was less so but overall the company has been resilient."

On the earnings call however management noted that order intakes for 3Q20 were down around 10%-17% with EBITDA roughly in line or lower than expectations.

CLICK HERE for the 1H20 earnings call transcript.

In 2019 there was a major short on the name but this was due to heavy one-offs and cashflow generation coming purely from factoring and inventory facilities, Sarria noted. But while there could be a 3Q EBITDA decline the business will come back, which ties in with PMIs across Europe, and 4Q should be back to normal while a reduction in exceptionals and capex means it could work out, it added.

KME Manshield

KME's earnings should improve in the coming year given upcoming synergies from its integration of the KME Mansfield business. Management noted it has realised EUR 8m of synergies year-to-date out of a target EUR 30m–EUR 31m, of which EUR 18m to EUR 20m is achievable in 2020. The integration of staff, sales and production functions could provide positive support to increased KME earnings in the coming quarters.

The group also has the potential to generate free cashflow and keep its low 3.0x reported net leverage in check. Based on 2Q20 LTM adjusted EBITDA of EUR 88m, EUR 29m LTM capex, around EUR 40m interest and around EUR 5m cash taxes KME could generate EUR 14m of annual free cashflow or 0.15x deleveraging per year ahead of working capital moves and exceptional items.

Whilst headline leverage looks reasonable, adjusted metrics are much higher. Although its facilities are undrawn in cash terms, there is a heavy EUR 372.2m letters of credit usage on its EUR 375m borrowing base KME facility and EUR 80.4m letters of credit usage on its EUR 146m KME Mansfield facility at 2Q20. Adjusting net leverage for these letter of credit draws and EUR 201m pension liabilities would mean adjusted metrics above 10x.

Being conservative and adding full capacity of its EUR 375m borrowing base KME facility, EUR 152m KME Mansfield facility, EUR 30m Intek working capital facility and EUR 201m pension would push adjusted net leverage towards 12x.

“The bonds are illiquid and if one wanted to buy a chunk it is almost impossible. When they came with the bond they had huge facilities and they show low leverage but if you add these facilities then it is much higher,” a second buysider said. “It is hard to get a read through on how sustainable the leverage and structure is. The security package is tough to judge and these were question-marks. It is tough.”

The issue is the leverage is low when just including the bonds but when considering the asset backed facilities it is higher, Sarria agreed. Many facilities are drawn on letters of credit and not cash drawings. The pension deficit is in Germany but the bonds are secured with shares in KME Germany and security on one plant (Osnabruck) so in principal bondholders have the right to the real estate and machinery in the plant. The security is strong so the pension is not an issue for this company versus a UK company, Sarria added.

The group has managed to keep net leverage low in the past through releasing working capital though it remains to be seen if this trend remains sustainable. KME had a EUR 53m working capital release in FY18 and EUR 87m in FY19.

Liquidity is healthy with the group having cash of EUR 75m on balance sheet and access to the above facilities to help cope with working capital swings.

Management also noted on the earnings call that KME has increased its borrowing base facility by an extra EUR 20m in 3Q with the KME Mansfield Tranche B bank facilities being upped from EUR 5m to EUR 25m. It is in negotiations to extend the February 2021 maturity of its EUR 375m KME facility borrowing base by two years while all factoring facilities have been extended.

“I’m positive and the factoring facility being extended means they are doing well while letters of credit are highly likely to be extended. The liquidity event negative people are looking for has now been removed,” a third buysider said. 

Intek: the next generation

There are two other reasons to be bullish on the outlook for KME, according to the third buysider. Firstly its shareholder Intek issued warrants of EUR 115m on 9 October, which means it has funds to support KME if needed.

KME management noted on the earnings call that if there was an opportunity to avoid creating a ratings default through bond buybacks then this opportunity would be explored.

Secondly, the separation of the Special and Copper division's legal entities has raised speculation over potential disposals. Management explained on the earnings call that it wanted to streamline the needs of each division and it would be easier to do the annual application for energy exemption costs for example. 

“Intek issued a warrant. Could it be to finalise M&A activity or even to refinance the KME bonds? The bonds at the Intek level were issued at a low coupon while the KME bonds still trade in the 70s,” the third buysider said. “If you separate the two legal entities, you don’t do it planning to run the business as normal. Since Intek took this over they sold the brass business and did the copper acquisition. M&A is a key part of their strategy.”

KME’s EUR 300m 6.75% senior secured 2023s are down over a point since the earnings call at 72.75-mid yielding 22.7%, according to Markit.

The key driver is exceptional cash outflows, which were above EUR 50m in FY19, Sarria noted. This depends on how one adjusts for committed stock measurement. The company has copper inventory on balance sheet but if the copper price falls inventory goes down and working capital does not release as it does with other companies. No cash has changed hands so the only change is the value of inventory booked on balance sheet. If one looks at other companies then there is a working capital release but positively this exceptional item has reduced in previous quarters, the firm added.

“There could potentially be more cash, the legal separation and fix while Intek has cash,” the third buysider said. “KME bonds are secured by the factory so they should be worth more than the value of the bonds currently.”

KME declined to comment.

by Adam Samoon