Sunday, 20 July 2014

Knowles, no not that one

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.