Keysight Technologies (NYSE:KEYS) is a high quality company that benefits from some of the biggest themes in investing, including 5G, electric & autonomous vehicles, and China. I'm bullish on the company long term, with only valuation giving me pause. In this article, we will explore the company's business, exposure to major themes, market, strategy, financials, valuation and risk factors. By the end of this article, readers should have a solid foundation on which to develop their own investment views.
Source: Keysight.com
Business
KEYS sells electronic measurement instruments and systems, software and software design tools used to make electronic equipment, and services related to its products.
KEYS spinoff from Agilent (A). The company was incorporated in 2013 and went public in 2014 after a series of divestitures. It is a notable positive that KEYS's senior management team came from Agilent and have decades of experience working with each other.
As a public company, it has been acquisitive. For example, in April 2017, it acquired Ixia and in August 2015, it acquired Anite. Today, the company operates under two segments: Communication Solutions Group (CSG) and Electronic Industrial Solutions Group (EISG).
Segments
The CSG segment is ~75% of total revenue and is expected to grow 11.4% in FY21 (ending October). There are two subsegments: Aerospace, Defense & Government (ADG) and Commercial Communications (CC).
The ADG subsegment, ~21% of total revenue, is mostly tied to defense and to a lesser extent aerospace applications such as satellites. Defense companies like Lockheed Martin (LMT) and Northrop Grumman (NOC) have traded poorly due to concerns over the defense budget, which may be pressured by the rising budget deficit and national debt. However, defense companies, including KEYS, believe the budget will likely grow to address the great power competition with China and Russia.
The CC subsegment, ~54% of total revenue, gets a lot of attention because it contains the exciting 5G business. ~30% of the company's revenue comes from wireless, which contains 4G and 5G revenues.
Excitement around 5G remains hot. For example, as of Jan. 5, the Federal Communications Commission auction of so-called mid-band frequencies has raised more than $78 billion, far exceeding any previous spectrum auction and blowing away most analysts’ expectations.
Source: Keysight.com
In 5G, KEYS's systems are used for testing devices, chipsets, networks and telecom equipment across the entire 5G ecosystem. Furthermore, KEYS systems are used for multiple use cases such as mobile devices, broadband internet and industrial applications. Broad usage of KEYS systems means the company is well positioned to benefit from many year after the initial 5G rollout.
The EISG segment is ~25 of total revenue and is expected to grow 9.5% in FY21. This segment serves a broad set of electronic industrial end markets, focusing on high-value applications in the automotive and energy industry and measurement solutions for consumer electronics, education, general electronics design and manufacturing, and semiconductor design and manufacturing.
Market
KEYS is a truly global company. The company's largest geography is APAC at ~43% of total revenue, followed by the Americas at 40% and Europe at 17%.
KEYS has ~25% market share of the $17.5B served addressable market (SAM) for electronic design and test & measuring across its end markets, making it the market leader.
Test and measurement instruments are used in R&D, prototyping, design and development of electronic products as well as during the production process to validate product functionality. Once the equipment is deployed, test and measurement instruments are used to monitor performance.
The SAM components include $8.5B in Communications, $4B in aerospace & defense and $5B in Electronic Industrial. The SAM has been growing 3-5% and KEYS has been outgrowing that through organic and acquisitions. For example, KEYS is expected to grow toppling by 11.3% in FY21 (ending October).
Key competitors include National Instruments (NATI), Teradyne (TER), Fortive (FTV), Rohde & Schwarz, Anritsu (OTC:AITUF), Spirent (OTCPK:SPMYY), and Advantest (OTCPK:ATEYY).
Bonus: China Exposure
I recently wrote an article arguing that investors should increase their exposure to China, and that decoupling is doomed to fail, so clearly I am bullish on China. China's economy continues to be the fastest growing in the world and is on track to overtake the US as the largest economy in the world, and has a massive middle class. Furthermore, I predict that geopolitical tension will ease under the Biden administration, and after that, China will be too entrenched in the global system to decouple.
If you are bullish on China, one of the best ways to gain exposure to the country is by making an investment in KEYS, which derives ~20% of its revenue from China. KEYS's China business has been growing very robustly in the mid-teens even through the height of the trade wars.
Strategy
Expanding software-centric solutions to increase recurring and higher margin revenues is a significant strategy for KEYS. Around 1/3 of KEYS's revenue comes from software and services, and the rest from equipments. Within software and services, around 1/3 is services and the rest is software. The company intend to continue increasing its software mix, which should drive margins up over time. To the end, the company has made tuck in acquisitions to expand its software portfolio, including the acquisition of Anite and Eggplant.
Financials
KEYS has an excellent balance sheet. The company ends 2020 with ~$1.8B in cash and cash equivalents, and the same amount of long term debt. Its net leverage nets out to zero.
The company spends between 3-4% of revenue on Capex, which is easily taken care of by its massive operating cash flow. Free cash flow has been growing since FY18 and is expected to continue through at least the next two years, growing at a low-teens CAGR.
On capital allocation, KEYS does not pay a dividend and instead focus on reinvesting profits (ROIC is roughly in the mid-teens but can fluctuate through the cycle), making acquisitions and share repurchases.
The company is committed to its long-term EBIT margin of 26-27%.
Valuation
All the fundamentals look great, but valuation is challenging. The stock is trading at 25x forward EPS, ~20x EBITDA and ~5.5x sales -- all metrics near its 5-year high.
But frankly, everything is expensive these days because the market is expensive. Relative to the S&P500, KEYS is trading at a 14% P/E premium compared to its 5-year high of 28% premium and low of a 20% discount. You decide, but it looks a tad high to me.
If I own a well diversified portfolio of individual stocks, I will likely own KEYS. However, my strategy is to own broad-based ETFs, which I buy and hold, and concentrated high alpha ideas that could be multiple baggers, which I may trade actively. KEYS does not appear to be a controversial stock and is well run, so it is trading at an appropriately high multiple. I will be watching KEYS closely for a more attractive entry point.
Risks
I identified two notable risks that are top of mind.
US-China relations may worsen: KEYS has one of the highest China exposure in the S&P 500. Although I believe this is a net positive, worsening trade and geopolitical relationship -- of the perception of it -- will likely weigh on the stock. However, I believe improving relations over the next four years is the more likely outcome.
5G demand may disappoint: I find it very difficult to predict 5G demand for KEYS's products and services. There is no doubt that investors are very optimistic and interested in 5G: as KEYS's CFO noted during the December 2020 Wells Fargo conference, "I spend a disproportionate amount of time talking about 5G." Bears argue that 5G demand may roll over once the R&D phase is over, while bulls point to the opportunity that will arise during the commercialization phase. It is too early for me to tell who will be right since we are only in the early stages of commercialization.
One Last Word
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