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Pace Plc - A share that has not run out of pace

Thesis Summary

Pace plc is the largest set-top box (NASDAQ:STB) manufacturer globally, serving over 100 customers, including over a third of the top 100 PayTV operators. While it was successfully turned around and generates a substantial amount of free cash flow, the market seems to believe that Pace has run out of steam and faces headwinds including commoditisation of the set-top box market and reaction from competitors. Nevertheless, at less than 11.0x LTM P/E and an estimated 8-10% free cash flow yield in 2010, given the growth prospects of the underlying market and the potential for Pace to continue grabbing market share and generate new revenue streams, the share price does not reflect Pace’s potential.

Description and Background

Pace is the world’s largest global developer of digital technologies for the PayTV industry (in 2009 it was second largest, with 14% market share by volume , while Motorola and Technicolor had 16% and 14% market share respectively). It manufactures set-top boxes, PVRs, media gateways for over 100 customers globally. In addition, it manufactures a unique product, Pace MultiDweller, which allows existing analogue TV networks (in say hotels, hospitals…) to redistribute digital content without the need for new infrastructure. This is a price competitive solution for hard-to-reach customers. Pace is listed on the LSE and is headquartered in the UK, with operations in France, India, the US and China.

In 2006, new CEO Neil Gaydon started to turn around the company, and in 2008 Pace acquired loss-making Philips France for £65m (0.3x revenue), turning it around into a profitable business. Management has expressed its openness to acquisitions, and has since acquired Bewan Systems in April 2010, for a maximum consideration of £11m (including earnout), which will allow Pace to improve its converged gateway and digital TV solutions to PayTV customers.

In terms of positionning, Pace is a technological leader, being the first manufacturer to announce hybrid PayTV and IP solutions, while it also has a lead in terms of “time-to-market”. These two factors are key to Pace’s relationships and should prove highly positive for the company’s growth plans and the protection of its margins.

Pace is positioned in the HD segment, which represents the majority of its revenues, and operates in the growing PayTV set-top box market (expected growth of 10%+ p.a.), which is set to grow at a fast pace in Latin America and Asia. Furthermore, HD penetration is at 7% globally, while studies show than even in markets where HD penetration is high (for example the US, where it is at 30%+), increasingly households are purchasing more than one HD television set, which will require additional set-top boxes. Given Pace’s technological positioning and the advent of 3D, ultra HD, plus growing demand in emerging markets and its unique MultiDweller product, Pace should be able to continue growing and taking market share from its rivals, which have been restructuring and face various constraints (Motorola by its phone division and Technicolor by its high debt burden).

Pace has net cash of £74m (December 2009, pre-Bewan acquisition), a market cap of £540m, an EV of £475m (5.5x LTM EBITDA excluding amortisation of development expenditure) and a trailing P/E of 10.7x, with a free cash flow yield of 6.7%. Pace trades at a discount to peers in terms of EV/EBIT and P/E ratios. Management has guided to mid-single digit revenue growth and gross margin improvements in 2010, and it has made some investments to improve reliability and intends to focus on growing the customer base in 2010 and 2011. At current price and given the flexibility that the strong balance sheet affords management, and management’s exceptional execution to date, there remains a lot of upside for Pace plc.

Key Catalysts for Thesis
  • Announcement of further customer wins, especially in emerging markets
  • Strong uptake of MultiDweller product
  • Continued market share increase or problems at Motorola and Technicolor
  • Continued accretive acquisitions
  • Further margin improvements (given management’s conservative estimates to date)
  • Lower R&D and capex requirements over medium term

Key Risks
  • Drop in consumer spending as PayTV is a consumer discretionary product
  • Commoditisation of set-top box earlier than expected (given large barriers to entry and significant economies of scale and requirement for technological innovation, this should not be a problem)
  • Diminished pricing power and pressure from suppliers
  • Competitors regaining market share
  • Continued high development costs and capex with lower returns than expected
  • Shortage of components

Other Factors
  • Insider buying recently at 190p (25,000 shares) support investment thesis that shares are undervalued
  • Technicolor, one of Pace’s main competitors, has debt levels of 5.4x LTM EBITDA, which will constrain it somewhat
  • Motorola, Pace’s largest competitor, is undergoing restructuring, with some believing that the set-top box division’s strong cash flows will be used to bolster the mobile phone division, which would constrain the set-top box business
  • Management has been exceptionally able, and has been conservative in the past, such that targets of 8% operating margins in the medium term may be lower than internal targets
  • Pace has a strong balance sheet and is well positioned in a growing market, such that it should be resilient to any further market turmoil

Conclusion

Given the outlook for Pace’s end markets, the company’s discount to peers, its innovative products, various potential for forecast upgrades  (especially in light of management’s previous conservative assumptions) and its strong balance sheet, which gives Pace a lot of flexibility in terms of strategy, I believe Pace’s shares represent great value at current prices. The fact that on 22 April 2010 a Non-Exec Director bought 25,000 shares at 190p supports the thesis that Pace’s shares have significant upside, while Management has been apt at executing its plans in the past, and has been excellent at disclosing information to date.

 



Disclosure: Long LSE:PIC