Description

Long KEYS - $97.41

We believe that Keysight Technologies (Ticker: KEYS) – a global electronics test & measurement (T&M) business – is a high-quality compounder that the market is currently overlooking. While most investors look at KEYS simply as a way to go long the upcoming 5G capex spend cycle, we believe the market is under-appreciating KEYS’s ongoing business transition to more of a recurring-software / “razor-and-razor blade” type model which will drive continued margin expansion, less cyclicality and a deeper entrenchment in customer operations. We also believe KEYS’s end markets have secular growth drivers beyond 5G that will result in continued R&D spending and new testing needs. Finally, the market is giving no credit for future capital allocation, which is a significant opportunity given an unlevered balance sheet and high levels of free cash flow generation. 

At ~20x our 2021 earnings/FCF numbers, KEYS is not “cheap”. Nevertheless, we see an attractive IRR from here because (1) we see forward guidance as conservative and see several levers the company can pull to meet or beat guidance, and (2) the sell-side seems to be giving minimal credit to any capital allocation or B/S optionality simply because historical capital allocation has been lumpy and infrequent. Finally, given KEYS can double earnings in 5 years while increasing its recurring revenue mix – something pretty rare in this market – we feel multiple compression is unlikely. 

Using what we believe to be some fairly reasonable assumptions around capital allocation, we see a path to EPS of around ~$8.50/share by FY2025 in our base case scenario, up from $4.18/share in FY20. At a 20x forward multiple, that is a ~$170 stock price by mid-2024 (all while maintaining an unlevered balance sheet) or an attractive mid-teens IRR from here. In a bull case scenario where management beats guidance and a little more capital is allocated towards M&A and buybacks, we see a path to $10/share by FY2025, or ~$200 stock price by mid-2024 (~18% IRR from here).

Business Overview

In 2014, KEYS was spun out of Agilent, which was in turn spun out of HP in 1999. While Agilent sells products that measure things that can be seen in the physical world (liquids, gasses, mass), KEYS’s products measure things in the electrical-signal/radio-wave world which are imperceptible to the human eye.  We highly recommend watching the most recent KEYS investor day on YouTube (https://www.youtube.com/playlist?list=PLvQ5Bzr3tM50lAqlApKQmOx70jSbrXY6K) to get a better understanding of what the company does and its competitive positioning.

Today, KEYS classifies its business into two reportable segments:

1.  Communications Solutions Group (CSG) [~75% of Rev; ~70% of EBIT] – CSG sells electronic measurement solutions primarily used in the designing and testing of communications services to a variety of customers across both commercial and governmental end markets. On the Commercial side, some customers include the large mobile device manufactures, chip manufacturers and telecom companies. On the Governmental side, customers primarily use KEYS’s solutions for designing and developing communications components for use in Aerospace & Defense applications, such as electronic warfare, the modernization of satellites, and global surveillance systems.

2.  Electronic Industrial Solutions Group (EISG) [~25% of Rev; ~30% of EBIT] – EISG sells electronic measurement solutions used in applications other than communications services to a wide range of commercial end markets. Examples of customers include auto OEMs, consumer electronics OEMs, and energy companies.

Investment Thesis

1.  KEYS is undergoing a business mix transformation which seems underappreciated by investors – More important than KEYS’s quarterly reported business breakdown (CSG/EISG) is its infrequently reported business breakdown by customer type and product type, as shown below. What’s important here is (1) KEYS’s growing focus on more R&D-facing solutions and (2) KEYS increasing its overall revenue from higher margin recurring software and services.

Broadly speaking, there is very little switching once a company starts using KEYS’s products as its costly to train people to learn a new platform, especially once they have gotten used to it. This is especially pronounced for R&D facing customers/workflows as the complexity of the design and testing that needs to be done today is an order of magnitude more complex than it was 5-10+ years ago. Furthermore, this increased complexity in the R&D of electrical components has also increased the need/value-proposition of the software part of the R&D process. By focusing on growing both their R&D-related revenue mix, as well as their recurring software revenue, KEYS will further entrench itself in its customer base, increasing stickiness and durability of revenues, as well as overall margins. We note that KEYS already has a materially higher R&D and recurring software mix than peers and we expect the benefits of this relative mix difference to become even more pronounced over time.

We also note another advantage in KEYS’s competitive positioning versus its peers – KEYS is unique in that it is nearly fully integrated for testing all the way up the OSI layer value stack (thanks to their M&A activity), as shown below. This was not the case during the 4G cycle, when KEYS was only focused on the bottom-most physical layer of the stack (things like testing fiber in the ground). Why is this important? As we move towards 5G (and 6G, 7G etc), testing at the protocol and application layers of the network architecture becomes far more important than testing at the physical layer because more advanced networks depend exponentially more on the “intangibles,” like network security and network visualization which lie in the protocol and application layers. This trend will not stop even as we move beyond 5G as it is primarily a function of the exponential growth in network data usage and the growing number of connected devices around the world. The market for testing at the network’s protocol and application layers grows many times faster than that of the physical layer and is also much more dependent on the software component of the testing process than the actual testing equipment used. KEYS is better positioned than most, if not all, of its peers to take advantage of this trend by being a one stop shop for its customers across all the network layers. This will further entrench KEYS’s customer base, especially as networks become more and more complex over time.

The memory of how cyclical this industry has been historically, combined with the 5G narrative taking the front seat, has led to an underappreciation of KEYS’s underlying business mix transformation to a stickier/higher-value-proposition business model. With KEYS’s recurring revenue mix growing from ~10% in 2015, to ~20% today, to ~25-30% over the next 5-10 years, we view an investment in KEYS as akin to a more-cyclical-version of an investment in Agilent 10 years ago (which grew its recurring business from ~45% to ~60% today).

2.  We view KEYS’s forward looking guidance as conservative and see several levers the company can pull to meet or exceed guidance – Relative to KEYS’s long term guidance given at their 2015 and 2018 investor days, KEYS has massively outperformed – as shown below – in large part due to early 5G spending, business mix shift towards higher GM products, and some above-normal SG&A/tax rate leverage last year. Going forward, we view KEYS’s long term guidance laid out at their 2020 analyst day as somewhat conservative and see several avenues through which the company can meet or beat guidance.

KEYS’s latest GM guide calls for 64-66% GM by 2023. Considering that the software mix expected to grow ~1%/year with gross margins 2x overall KEYS and that services gross margins (now in the mid-40s) is expected to improve by 10% over the next 3-4 years, 64-66% GM by 2023 shouldn’t be difficult to achieve at all. We note that even our assumption that software mix grows ~1%/year (i.e., about +$100m/year) may also prove to be conservative as the company has disclosed that 5G revs (~$500m as of FY19; growing 50-100%) going forward are expected to be 40% software.

Opex spend related to KEYS’s Ixia acquisition is another lever the company can pull to improve margins. The Ixia deal, which KEYS closed on in April 2017, was incremental to KEYS’s TAM and immediately accretive to both the topline (mid-teens growth) and gross margins (~80%). EBIT margins for the business have been lackluster, however, as shown below. We calculate that simply cutting opex and bringing Ixia EBIT margins up to the rest of KEYS’s business would add ~2% to overall KEYS EBIT margins. This in and of itself would get KEYS to their FY23 EBIT margin guide of 26-27%.

3.  KEYS has ample B/S flexibility and street numbers do not give credit to any capital allocation – Historically speaking, KEYS’s management team have been prudent and infrequent allocators of capital. Net leverage has never gone above ~2x and, as of 2FQ20, the B/S is in a net cash position. Naturally, given the infrequency of historical capital allocation, the sell-side has opted not to model any returns from capital allocation into out-year numbers, when in reality this is likely not what will happen.

Between 2021 and 2025, KEYS should be able to allocate ~$6-7Bn of excess cash (30-35% of current market cap) and still be able to maintain a roughly neutral net leverage position on the B/S. Management’s first priority for this excess cash will be opportunistic M&A, followed by share buybacks if they cannot find any attractive targets. Management’s criteria for M&A is fairly stringent – the target must have high software content/recurring revenue, must be accretive to topline growth and gross margins, must have both revenue and cost synergies, and of course, ROIC must be higher than KEYS’s cost of capital (~7%). In reality, KEYS’s returns on M&A should at least come in in the teens area and possibly around 20%, given KEYS itself is able to generate ~20% returns on its own with organic re-investment internally. If we simplistically assume all of that $6-7Bn of excess cash generated from 2021 to 2025 goes towards M&A at a 15% return, that in and of itself would eventually generate an incremental $4.50-5.50 in EPS each year (vs $4.72 FY19 EPS).

Earnings Outlook/Valuation

Below, we show an abbreviated model with our base case and bull case earnings outlooks through FY2025. In our base case, we assume management simply meets its long-term top-line and margin guidance, despite their history of being very conservative on guidance. While we don’t know how KEYS will allocate its capital going forward, we doubt that they just let cash continue to build. We assume a 50/50 split between M&A and buybacks, with after-tax ROIC on M&A at 15% after 3 years and buybacks being done ~20% above current levels. Even with $1.2Bn being allocated between M&A and buybacks each year, KEYS should still be able to maintain a roughly neutral net leverage position through the entire projection period. In our bull case scenario, we assume slightly better revenue growth and margin performance, as well as more capital allocated each year towards M&A and buybacks ($1.5Bn/yr in the bull case vs $1.2Bn/yr in the bear case).

Under our base case assumptions, we arrive at EPS of ~$8.50/share by FY2025. At a 20x 1-yr forward P/E multiple, that is a ~$170 stock price by mid-2024 or a mid-teens IRR from here (all while maintaining an unlevered balance sheet). In our bull case, we arrive at EPS of ~$10/share by FY2025, or a $200 stock price by mid-2024 at a 20x 1-yr forward P/E multiple (i.e. ~18% annual IRR from here).

Catalyst

- 5G capex spend cycle

- KEYS’s underlying business mix transformation, regardless of 5G, beginning to come to light

- High growth/margin accretive M&A