Over the past two years Avago's (AVGO) earnings, share price and profile have all received a significant boost courtesy of its role as an enabler of the smartphone revolution, including its potential for outsized growth from increasing 4G / LTE penetration and its recent entry into the iPhone supply chain. But while this particular leg of Avago's growth story is certainly worthy of the attention it's getting, followers of the stock may be well served by shifting part of their focus to one of the company's lesser known product groups - its industry leading components for factory automation.
Having taken the view that China is on the verge of a boom in investment into factory automation, investors here in Asia are scrambling to identify companies with any meaningful exposure to this value chain. Thus far I have yet to see a Wall Street analyst make more than a passing comment on Avago's role in factory automation. To be fair, management does not make much of it either with these products tucked away in the industrial and automotive segment of the company's reporting. But after piecing together various disclosures, I guesstimate that factory automation related products contribute roughly 20% of Avago's gross profit* - i.e. enough to matter if the bullish outlook for this secular theme becomes reality.
At the core of Avago's exposure to factory automation is its dominance in a product known as the optocoupler. These are complex electronic devices used to prevent high voltages or rapidly changing voltages on one side of a circuit from damaging components or distorting transmissions on the other side. It's no surprise that optocouplers are an essential component in factory automation given the expensive high voltage robotics and related systems involved. According to Frost & Sullivan, Avago is the world number one in optocouplers with a 20% share of the overall global market and a dominant 65% share of the higher specification end of the market.
By nature, factory automation equipment is a wide moat business, with leading edge products being technology intensive and requiring high degrees of precision in the manufacturing process. Even in China, most large manufacturers are unwilling to venture beyond the best of breed suppliers when outfitting their high tech factories to meet exacting customer specifications. This translates to healthy margins for those automation equipment providers that are able to make the grade. Although Avago does not give a specific breakdown of margins by product segment, it has disclosed that margins for the industrial and automotive segment are well above the consolidated average. Some analysts estimate gross margin for this segment to be 55-60% versus the overall gross margin of 50-52%.
So why should we suddenly start caring more about Avago's factory automation exposure? Despite the significant slowdown in China's economy, rising labour competition pushed up monthly wages for unskilled labour rose by 17% in 2011. Chinese manufacturers are expected find it increasingly difficult and expensive to hire workers. A recent World Bank study concludes that China's labour force will begin shrinking in 2015. In order to sustain economic growth as its working population declines, China will need to increase its capital investment per worker. That's economist speak for increasing automation. Of note, the penetration of robots in the manufacturing process in China is estimated at less than one tenth of that of the US, Germany or Japan
Rising focus on labour rights in China is also forcing companies to accelerate automation. A recent Financial Times article argues that the Chinese government is increasingly supportive of automation as a means to improve labour conditions. Perhaps more importantly, this sentiment is shared by the customers of Chinese factories including none other than Apple (AAPL), whose supply chain has come under intense scrutiny by rights activists in recent years.
Apple watchers highlight that the combination of strong demand growth for Apple products as well as their increasing complexity have also led supply chain guru Tim Cook to focus in on the critical role that production automation will play in the company's future. Look no further than Apple's explanation that the doubling of its capex budget in 2012 to $8bn will be driven by expenditure on "product tooling and manufacturing process equipment", or to recent headlines that key supplier Foxconn Technology intends to increase the number of robotic arms in its factories from 10,000 in 2011 to one million by 2013.
Despite the compelling secular drivers of automation, slower global growth and monetary tightening in China have been powerful cyclical headwinds of late. Avago's industrial and automotive revenue fell by 26% y-o-y in 2Q12, leading to a decline in its contribution to total revenue to 22% from 30% in 2Q11. It's estimated that about two thirds of robot demand and half of machine tool demand in China comes from the auto industry, which has fallen on tough times.
All this may, however, be about to change. The emerging demand from electronics manufacturers like Foxconn should begin to offset the weakness in demand from the auto companies, while the loosening of monetary policy has the potential to unleash a wave of pent-up spending on factory automation. In the past it was only the larger well-funded Chinese companies that were interested in getting automated, but now there are signs that the surge in labour costs has begun to push demand down to the medium sized business level. For the past two years, however, capital spending by these smaller companies has been restrained by very tight credit conditions.
We may already be seeing signs of the secular demand outlook for automation trumping the economic cycle. Despite sluggish global economic growth and as yet minimal easing of monetary conditions in China, Avago's 3Q12 guidance for the industrial and automotive division called for a "continued strong recovery worldwide which should favorably impact consolidated gross margins". If demand for AVAGO's automation products can begin to beat the cycle it will come as a surprise to Wall Street analysts, most of whom forecast the company's industrial and automotive revenue based on the trends in the PMI and or ISM.
In addition to being a potential source for upside earnings surprises over the next several years, Avago's strong position in factory automation may also drive a re-rating for the shares if these products can serve to reduce the cyclicality of overall earnings. I would also argue that Avago's valuation does not reflect the "scarcity premium" that seems to be awarded to factory automation plays globally. This scarcity is due in part to the relatively small number of players in this space and in part to the fact that the big engineering companies like Siemens (SI) and ABB (ABB) (major buyers of Avago's automation components) that dominate the value chain are far too diversified for them to offer investors meaningful exposure to the thematic.
Here in Asia, industrial robot giant Fanuc (OTCPK:FANUY), which is about as close as one can get to a pure play on factory automation, trades at 17X PE, while automation component producers in Taiwan trade at big premiums to their tech sector peers - e.g. Hiwin and Airtac both at 18X. By comparison, Avago at 14X looks like a steal.
Given the bullish outlook for factory automation we would not be surprised if Avago management eventually renames the industrial and automotive reporting segment to 'industrial and automation', at which point we would have to assess whether this compelling thematic might finally be in the price. Until then, Avago's overlooked exposure to this secular growth story offers scope for both positive earnings surprises and a re-rating.
*Avago's 2011 annual report shows that its 'industrial and automotive' products contributed 29% of revenue. My own discussions with company IR indicate optocouplers contribute roughly half of the sales of this product segment. The majority of optocouplers are used in factory automation but not all. But considering that the industrial and automotive category includes other products used in automation like industrial fiber and motion encoders, I believe it is fair to assume automation products in total comprise at least half of the industrial and automotive revenues or roughly 15% of total revenues. Adjusting for the higher than average gross margins of these products the contribution to gross profit should be close to 20%.