Methode Electronics: Missing A Spark To Regain Momentum

Summary

• Methode Electronics' latest quarterly result missed expectations.
• The company has been benefiting as a supplier to electric vehicle manufacturers while other segments are pressured by macro headwinds.
• We believe weak sales momentum will keep shares volatile.
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Methode Electronics Inc (NYSE:MEI) is a global supplier of custom-engineered mechatronic solutions covering applications in everything from the automotive sector, and aerospace, to construction equipment, computing infrastructure, and even medical devices. Demand for specialized components, particularly utilized in electric vehicles has supported solid growth in recent years.

On the other hand, headline-making supply chain disruptions and inflationary cost pressures have been a theme over the past year, pressuring earnings. The company recently reported its latest quarterly result which missed expectations alongside soft guidance, leading to a sharp selloff from recent highs.

Our take is that until MEI can demonstrate a more convincing growth rebound and sustained earnings momentum, the upside in the stock may be limited. The company maintains a positive long-term outlook but we expect the volatility in shares to continue.

Data by YCharts

MEI Earnings Recap

MEI reported its fiscal 2023 Q3 earnings with a GAAP EPS of $0.54, down from $0.78 in the period last year, and also $0.15 below market estimates. Materials cost inflation hitting margins and some unfavorable FX impacts have limited profitability. This was reflected in an adjusted EBITDA margin of 12.9%, down from 16.4% in Q3 2022.

Net sales of $280 million declined by -3.9% year-over-year and were also below estimates. The drop here considers the timing of a large "North American auto program" roll-off, which is related to the company's relationship with General Motors (GM).

Simply put, Methode was historically a major supplier to GM's legacy internal combustion engine-based platforms while the effort more recently is to shift towards a focus on electric vehicle applications. For context, GM represented as much as 50% of the overall business back in 2016 and that level has now dropped down to around 20%. This greater diversification into other customers is a strong point in the business profile but has left this type of overhang in the quarterly results.

source: company IR

At the same time, the demand strength for EV solutions as a global theme is expected to continue. Management notes that through Q3, the company has captured $382 million in contract awards in this segment, up from $262 million in all of 2022.

source: company IR

An important development this quarter was Methode's acquisition of "Northern Lights", a company with complementary solutions in OEM lighting while adding business in the industrial and non-auto transportation markets. The deal was valued at approximately EUR 132 million in cash and is expected to close in the calendar year Q2 (the fiscal Q4), while accreditive to earnings for fiscal 2024.

The transaction was facilitated given Methode's balance sheet cash position of $165 million against $201 million in debt. With annualized adjusted EBITDA trending around $140 million, the net leverage ratio should remain around 1x for the rest of the year.

As mentioned, the disappointment here largely comes down to the weaker guidance. Methode has been revised lower its full-year fiscal 2023 sales target to between $1.155 and $1.18 billion, compared to a prior midpoint target closer to $1.185 billion. Similarly, management now expects EPS around $2.55 compared to $2.80 estimate last quarter. The shift here cited the softer Q3 trends and demand weakness from the Asia region connected to slower data center activity.

source: company IR

Is MEI a Good Stock?

The attraction to MEI comes down to its exposure to important high-level market themes where mechanical and electronic components are becoming more advanced, integrating more technology.

In "user interfaces" which represent 56% of total sales, these are the by-wire controls, touchscreens, and center consoles most people would be familiar with in an automobile but are also found in industrial equipment. LED lighting is also a big business for Methode. Here the company captures trends in energy efficiency that extends to solutions for power distribution and sensors. It's fair to assume the world will need more of these types of products going forward.

source: company IR

Still, it's clear these markets are cyclical, where demand is dependent on trends in economic activity. The concern here is that current macro conditions based on high-interest rates and still stubborn inflation will being to impact sales performance.

According to consensus estimates, the forecast is for flat 2023 sales compared to fiscal 2022, while 2024 just sees a tepid 1.5% rebound at the top line. This means that even with the Northern Lights acquisition, the deal simply balances the weakness in some of the legacy categories. On the earnings side, the market expects 2023 EPS at $2.53, consistent with management guidance, but just a 3% increase for fiscal 2024 to $2.60. Again, not much to get excited about.

source: company IR

What stands out in the outlook is the expectation that growth re-accelerates in 2025 and EPS makes a bigger move forward towards $3.69. This follows management guidance for a 6% compound annual growth rate over the period, leveraged into higher margin potential. If anything, we're simply skeptical that the rebound will materialize at that pace.

In terms of valuation, we'll note that MEI is trading at 16x year ahead earnings multiple or 9x on the EV to forward EBITDA metric. On this point, even with the recent selloff, shares continue to trade at a slight premium relative to their historical average earnings multiple. There is a case to be made that the more recent focus on electric vehicles can justify a higher spread, but what missing is the growth.

Data by YCharts

MEI Stock Price Forecast

We rate MEI as a hold, balancing what we see as solid fundamentals between consistent profitability and the balance sheet position, against the soft near-term outlook.

From the stock price chart, MEI has essentially been stuck in a trading range between $50 and $35 since late 2020. Our base case is that it will continue to consolidate around the current level for the foreseeable future. While the downside may be limited based on the current information, we don't see enough of a compelling reason to turn bullish. Cash flow trends and the adjusted EBITDA margin will be key monitoring points over the next few quarters.

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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.