Despite the recent run after the Barron's article, we think the shares of LittelFuse (NASDAQ:LFUS) represent a compelling long-term holding given strong management capital allocation and a key eye on value-added acquisitions. We think the shares have been held back due to the forecasted margin contraction story that has plagued the firm, given weaker end-markets. However, we think that has been overdone and impounded into the shares and believe the strong top-line growth over the next several years will propel earnings power.
Littelfuse is a supplier of circuit protection products for the electronics, automotive, and electrical industries. They also produce a line of electromechanical and electronic switch and control devices for commercial and specialty vehicles as well as sensors for the automotive safety system space.
The firm operates in three markets: Electronics (48% fiscal 2013 revenues), Automotive (35%) and Electrical (16%). They are spread globally with 45% coming from the Americas, 18% from Europe, and 36% from Asia-Pacific.
The Automotive Segment Should Drive Additive Growth
The company's automotive segment has been providing much stronger growth to the firm and should drive higher organic sales over the next several years. While the automotive segment is now 35% of sales, that is up from just 28% three years ago, aided by strong growth and acquisitions. We think the segment will continue to grow between 7% and 10% per year driven by overall strength in worldwide automobile sales as well as increased content per vehicle.
Management has noted that they typically have $3 to $4 in sales per passenger car sold but as sensors and new electronics are continuously added to new models, that is inching higher. Electric cars can have as much as $20 in part sales per vehicle. As the spate of electric and hybrid vehicles surges, this should help propel the growth rate of the segment.
The company acquired Accel AB, a Swedish maker of sensors and electomechanical products, and Hamlin, a sensor technology company, in 2012 and 2013, respectively. They also acquired Cole Hersee which makes power management sensors for commercial vehicles. The acquisitions have created an automotive sensor powerhouse that is likely creating a competitive advantage - as well as placing a target on their back for acquisition.
Management plans to increase their acquisition activity in order to pursue other vertical growth markets within the sensor and power control product space. Given the large cash position and ample liquidity, we think they will likely pursue some larger companies, perhaps larger than $1 billion in revenue.
The Balance Sheet Adds Greater Flexibility to Pursue Accretive Additions
The company has over $378.3 million in cash on hand, 17% of the current market capitalization. We think they are going to be very active in the sensor market and will be adding several smaller firms, and possibly a few larger acquisitions. The automotive sensor market is highly fragmented. Management thinks they can add accretive transactions leveraging their own teams and production while adding new product lines.
In the meantime, it is highly likely they will also optimize their capital structure leveraging up the balance sheet to as much as 2.5x EBITDA, from the current 1.3x. It should be noted that this is already occurring as their debt-to-EBITDA ratio was just 0.6x two years ago. The company has entered into new credit facilities over the last couple of years in order to prepare for greater leverage and implement their acquisition strategy.
In addition to cash-on-hand and credit facilities to tap, the firm is a cash machine generating significant free cash flow that it can use to fund acquisitions. Cash flow from operations totaled $61.8 million in the quarter ended September 30, 2014. With cash flow from operations at 28% of revenue, they can easily fund some smaller acquisitions as well as a hefty dividend payout and share repurchase program.
Margins Have Held Despite Sluggish Global Growth
Margins have held up even while sales were down 1.5% qoq, but up 8.2% yoy. Management blamed this on a seasonal decline on the automotive and electronics segments, which were down 1.7% and 2.0% sequentially, respectively. Operating margins jumped to 18.9%, up from 16% in the second quarter, led by very strong margins in the Electronic segment which were nearly 24% for the quarter. Management notes that the strategy shift towards smaller form factor products with performance characteristics that differentiate them in the marketplace, drove the results.
Operating leverage from the strong sales growth was evident across all product categories, especially semiconductors. We think a significant amount of the move higher over the last two weeks has been the margin compression story being largely debunked. The adjusted operating margin of 19% in the quarter was their best quarterly margin performance in the last 3 years.
We think one of their primary growth strategies will be to pursue value-added custom opportunities. Management wants this ad-hoc business to solve unique application challenges for their customers and create another differentiator between them and their competition. These custom-design sensors help secure longer-term relationships in many industries while augmenting top-line growth with higher margins.
Five-Year Growth Strategy
In 2012, the company initiated a five-year growth strategy that was meant to grow the firm. The plan calls for a doubling of revenue off their 2012 base to $1.3 billion by 2017. The growth would be a combination of organic growth and through strategic acquisitions, which we detailed above. Annual revenue growth is targeted at 15% with 5% coming organically, with the remaining 10% coming from acquisitions.
In the second year of their five-year plan, they have had acquisition growth from Accel, Hamlin, and Symcom, resulting in an 8% compound annual growth rate. Management noted that this was short of their 10% target, but that they are still optimistic in their ability to close the gap over the next three years. They also stated that the rising valuations and expensive prices in the space have held back their pipeline as they have remained disciplined and only will engage in deals that meet their strategic fit and valuation benchmarks.
We like the industry and have written up several articles on the automotive space. The long-term industry dynamics are very favorable, especially within Asia, where LittelFuse derives 36% of their revenue. New cars are increasingly becoming "computers with wheels", with software downloads and a massive amount of sensors. As cars become even more computer driven, we think LittelFuse will be able to add more content in each car and significantly expand their sales base. As we noted in our recent Cooper-Standard article, car manufacturers are moving towards global platforms, favoring global part suppliers. With each new acquisition, the company steadily becomes are more dominant player in the sensor space with a larger global footprint.
Right now, the shares trade at a slight discount in relation to their peer group. LittelFuse is currently trading at 10.2x ntm EV/EBITDA, compared to their group which averages 11.3x. The disparity between the individual comps are large ranging from 6.1x to as much as 20.5x. In these situations, we ascertain the potential growth rate of earnings over the next five years and apply our own metric to return a warranted ratio.
We think the firm can grow earnings by 12% to 15% per year, which includes operating margins staying flat to down slightly over the time period. Under that scenario, EBITDA should grow to $215 million in fiscal 2015 and perhaps $235 million by the end of 2016, should the current momentum be maintained. At 11x that EBITDA, it implies an enterprise value of $2.58 billion. Netting out the debt and the cash leaves an equity value of $2.68 billion, or $119 per share, for upside of 20%.
The near-term upside case will come from a surprise acquisition that would be a strong fit for the company, with the right price paid by management. If that occurs, we could see much strong upside potential given the synergies and potential leveraging of the current platform. Downside risks would stem from integration issues with any of their recent acquisitions or a sustained weakening in their end-markets.
Over the long term, as the industry moves more toward electric and other highly computerized vehicles, their content per vehicle should move higher. We calculate that if content per vehicle moves from approximately $3.50 per car to $5.00, it would equate to earnings power of over $6 per share. Recall that electric vehicles command $20 per vehicle in sales for LittelFuse. As hybrid and all-electric cars expand in use, we think the $5 per vehicle in content is very achievable. In fact, our bull case would anticipate $7.50 in content per vehicle by 2018 equating to $7.25-$7.50 in earnings power.
We like the Littelfuse business and its exposure to the burgeoning automotive sensors and power controls market. As cars become more like mobile computers, the number of sensors and other circuit protectors will increase exponentially supplying a long-term tailwind to firms like Littelfuse. We think the shares were suppressed by a false margin compression notion due to the large, fragmented industry and little pricing power by the suppliers. However, that thesis has failed to materialize as end-customers rely on known suppliers, favoring reliability instead of focusing on price. Saving a $1 per vehicle but risking a supply constraint or lower quality product makes little sense in the automotive realm. We think the shares could see sustained low-to-mid double digit growth over the next five years.
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