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Methode Electronics (MEI) ( $11.91) is a manufacturer of electronic components in the midst of transforming from an auto supplier to a broader, product-driven model. Singular Research believes that MEI's discounted valuation offers an attractive entry point ahead of future growth, and is initiating coverage with a BUY rating.  

INVESTMENT THESIS

Methode Electronics (MEI) offers an attractive entry point for value investors looking to invest in the continued adoption of next-generation electronic technologies.

The stock is currently trading at a sizable discount to its recent 5 year average EV/EBITDA multiple due to the realignment of MEI's auto business as well as overall difficult macro-economic conditions for the US auto industry.

We expect auto segment sales to bottom in FY:09, with a rebound in FY:10 and beyond driven by new contract wins with OEMs such as Chery, Lusaw, and Southeast Motors in China, and a global small vehicle platform for GM (GM) in FY:11.

Further growth in the auto segment is expected as more MEI products/technologies, such as TouchSensor and MDI are incorporated on additional OEM platforms.

In addition to auto, MEI's patented switch and sensor technologies have significant market opportunities in verticals such as aerospace, telecom, alternative energy, and consumer appliances (among others). In many cases, MEI has multiple technologies that have application in a given vertical. For example, in alternative energy, wind turbine installations use MEI's Power Conversion, Bus Bar, Cable Management, and Heat Sink products. Hybrid and electric vehicles use TouchSensor technology for dashboard consoles, along with MDI Sensors in the transmission. With MEI shares currently trading at 4.5x ttm EBITDA and 11.3x ttm EPS, we feel the market has discounted the current weakness in the US auto market. Given the rebound we expect in MEI's auto business based on new contracts already in place for 2010 and beyond, combined with significant applications in many other verticals, we rate the shares BUY.

Over the last several years, MEI has made significant progress diversifying its business from a heavy reliance on auto supply business dependent on two customers - Ford (F) and Chrysler. Automotive sales now account for roughly 65% of sales, down from 80%, with a long-term goal of 50%.

Over the long-term, this reduced dependence on automotive sales will come from faster relative growth in other areas. We expect MEI to continue broadening its product offerings to further become a premier provider of next-generation interface, sensing, and connection technologies. Industry is just beginning to scratch the surface of what is possible with applications such as field-sensor switches, non-contact sensor technology, and "smart" devices. Many of these applications have also received a significant push recently thanks to skyrocketing energy prices.

As a result, demand for high-efficiency devices with "smart" interfaces is growing. For example, many utilities now actively promote "load-balancing" initiatives where customers are urged to run appliances such as washing machines at night, when power is cheaper. Next-generation, smart appliances make adoption of such behavior significantly easier for the consumer, where inertia is a decided hurdle to action.

The auto industry is also at the epicenter of the energy consumption conundrum, with automakers in the US finally shifting course from trucks and SUVs to more efficient platforms. Over the long-term, technologies that can improve operational efficiency offer OEMs the most potential for sales growth. Within MEI's product portfolio, MDI Sensing technology can be used in transmissions to aid efficiency, which may add several miles per gallon to performance.

COMPANY OVERVIEW

MEI has been in business for over 60 years and until 2001 was run as a family business predominantly serving two main automotive customers - Ford and Chrysler. Despite being publicly-traded, the business continued to be tightly-held and thus tightly-controlled by the founding family until being fully bought out in 2001, concurrent with the elimination of the company's dual stock structure (formerly METHA and METHB). With the transition to a fully-independent, autonomous organization, the entire board was reconstituted and is now a significant asset for MEI, led by chairman of the board Warren Batts. The current board counts eight of nine members as independent, with CEO Donald Duda the only non-independent member. The other eight board members include financial, technical engineering, merger/acquisition, and Asian export and distribution experts.

After the elimination of the dual-stock structure, management focused on the long term transition of the business model. MEI had historically derived most of its revenues from sales to US automotive OEMs. Non-US operations shipped a majority of their production back to the US. A long term strategic plan was put in place that focused on increasing organic growth; completing strategic acquisitions; and expanding MEI's global presence, all of which would serve to diversify the overall business beyond automotive while also diversifying the automotive business itself. As of today, MEI has operations in Mexico, China, and Europe, in addition to the US, and has completed a number of strategic acquisitions which have significantly expanded the product offering.

PRIMARY RISK FACTOR

MEI is in the midst of significant "turnover" in its business. Most notably, Chrysler, which has been a long-time MEI customer, is in the midst of discontinuation due to lack of profitability. Similarly, other products that carry slim profitability such as PC Cards, are also being phased. The lost revenues due to discontinued businesses are being replaced by new technologies, such as TouchSensor and MDI. However, these products have a shorter track record and narrower customer bases. If MEI is unable to "turn over" the business as intended, revenues and earnings will drop as costs associated with new products, particularly if acquired via acquisition, do not translate into revenue growth.

Also, MEI currently derives a significant portion of its overall revenue from its top 3 customers. Ford, Chrysler, and Delphi combined for 48.3% of overall revenues in FY:08, with Chrysler representing 13.8%. The remaining Ford and Delphi business thus accounts for nearly 35% of revenues and places MEI at risk should one of those two discontinue its relationship with MEI. Over the long term, the addition of multiple new OEMs and inclusion on more platforms with other, current customers such as GM will help reduce this customer concentration.

Disclosure: none

Source: Methode Electronics: Discounted Valuation Ahead of Future Growth