One good
thing about the return of animal spirits is the increased corporate activity resulting
in restructurings, spin-offs and so on to “unlock and/or create substantial
value for shareholders” (or whatever presentations say nowadays). Sarcasm apart,
there are often gems that surface into public ownership, which are part of
larger conglomerates, operating in different segments, making them non-core
from the company’s/shareholders’ perspective. Thus when shares of the new entity are
distributed to existing shareholders, the shareholder base is oftentimes not
“natural” and it takes some time before shares move to investors who can better
value such situations. I believe that this is the case at hand with Knowles
(KN).
Up until
2014 February KN was part of Dover Corp, an industrial conglomerate,
when it was spun-off. Rationale given at the time was that while it’s a high
growth business the capex requirement for Knowles was too much for Dover as it
would have starved it’s other businesses. They wanted to focus on their slower
growth albeit more predictable businesses hence the separation was pursued.
Dover market cap now around $15bn ($13bn around the spin) while Knowles is
$2.5bn. Furthermore, Dover pays a dividend while Knowles not (and not likely in
the next few years due to reinvestment). So the above gives a flavour of why
there is a difference in shareholder base. The two companies have very
different business models and the implied “higher volatility” of the tech
segment is clearly something industrials investors wouldn’t consider.
Knowles is essentially
a technology company that sells (a) microphones, speakers and other audio
equipment that go into mobile phones, tablets etc (c. 60% of sales; Mobile
Consumer Electronics segment) and (b) components for hearing aid, defence and
telecom use (c. 40% of sales; Specialty Components segment). Dover built this
business by acquiring competitors along the way.
In 2013 KN
generated $1.2bn sales (64%/36% split) and $274m EBITDA (70%/30% split, before
overhead). Overall, it’s 8.7% increase in revenue year on year driven by a 16%
revenue increase in MCE from higher volumes mostly in smartphones but drop of 2%
in SC due to drop off in government spending and lower demand for specialty
equipment in hearing aid. It’s
worth highlighting that the SC segment is prone to fluctuations in government
spending, telecom industry capex, which impact results.
There are
almost two different businesses within KN. The SC segment is not terribly
exciting from growth perspective, however KN does command the market in the
supply of hearing aids and related solutions (65-70% share) with one meaningful
competitor in Sonion (Danish private co, which just got taken out by Novo A/S).
Aging, albeit more affluent and technology savvy population bodes well for the
use of the currently under-penetrated hearing aid market. KN is developing new
technology in this area and sees possibilities to use technology from it’s other
segment (MCE) in hearing aids, which could make the end product less expensive
by reducing high labour costs in the manufacturing process via automation.
MCE will
grow more rapidly (and has grown - 52% since 2011) as handheld devices are
becoming more sophisticated acoustically. KN’s focus is on microphones and
according to third-party/company estimates the company has a 60-70% share of
the market (total market of c. $0.7-0.8bn). In terms of the speakers, it has an
estimated 15% share (behind AAC – 50% share and Goertek with 25%). Overall, KN
is no. 5 in the entire MEMS market (micro-electromechanical systems, essentially
the miniature equipment that goes into devices; don’t worry I had to get my
dictionary as well) behind the likes of Bosch, HP and so on.
The key to
the story is higher quantity and quality audio equipment that goes into
handheld devices. The current average audio content of a smartphone (such as
speakers, microphone etc) is between $2-3, which is expected to grow to $3-5
over the next few years. As the below chart shows prices of new products that
go into smartphones are clearly following the trend of falling off after a
while (indeed Knowles has cut pricing historically, though this is likely on
the older equipment; if you look at product pricing of phones or tablets
they follow a similar fashion) but coming in at higher levels vs before. Simply
put, users want better sound quality in phones, whether its microphones for
talking or recording HD videos or speakers for listening, voice control is just
coming into life as well as wearable devices.
Source: Knowles presentation
Barriers to
entry are high and KN’s moat comes from the fact that the product life is very
short (just look at a release of a new iPhone/iPad every year) and getting new
products that are more complex to scale would be tough for a new comer and not
to mention the ongoing R&D (around 7% of KN’s sales). What’s interesting is
that Nokia and Blackberry were both customers of Knowles emanating from a
previous acquisition. As these companies all but blew up KN’s sales grew
through as its products are practically in every OEM and the impact should be
eliminated later this year so fundamentals would be improving.
A few years
ago, KN began an internal restructuring process which management pegged at
$40-50m annualised cost saving of which around half has been completed by end
2013. The company is reducing its manufacturing
facilities from 18 to 11 and moving them to lower cost locations. On a recent
earnings call they noted the possibility to bring these cost savings a bit
forward in timing, which will help margins improve faster. Management guides
operating margin expansion to 22% from the historical 17-18% partly generated
from the above (on a non-GAAP basis mind you).
So what’s it
worth? The listing took place at $30 per share and despite a lot of trading
activity the price has gone…nowhere ($29 now). At current prices the company is
trading at TTM EV/EBITDA 10x and forward around 9x. This is roughly in line
with the historical multiples of Dover. The two closest peers are AAC
Technologies (2018:HK) and Goertek (2241:CH). AAC traded
at 14-15x historically and Goertek now trades at 14x forward. While getting to AAC multiples would probably
be a stretch as it generates EBITDA margins in the mid 30s, I think 10-11x is
not out of the question. Interestingly, Goertek generates KN like margins and
still trades at a premium. It is noteworthy that both AAC and Goertek are
essentially manufacturers for OEMs using third party technology while KN has
in-house research and design.
Let’s take a
conservative approach: sales growing at 5% through 2015 (about half of
historical), margins getting up to 25%, 11x multiple (20% discount to AAC) gets
you to a share price of $40 (vs $29 current). Assuming flat margins and 10x
multiple (more or less status quo) will get you to $30. Assuming, 25% margins
and only a 10% discount to the multiple will get you to $46 per share.
So: increasing
unit sales x increasing unit prices x expanding margins = $$$
Add a potential multiple rerating and we have an interesting situation on our hand.
