Description

Idea

Anritsu is a leading vendor of “Test & Measurement” equipment used predominantly for testing smartphone cell-network connectivity. This is a product upgrade-cycle story that we believe is coming to an end. Anritsu has benefitted from a gold rush in customer demand in the ongoing 5G investment cycle, as participants across the supply chain upgrade old 4G test equipment, which has led to a 5.5x in EPS over the past three years.

We expect Anritsu’s currently elevated earnings to peak in FY 2H21 (ending 3/31/22) alongside patterns established in prior cycles as 1) customers’ equipment upgrade cycle completes and 2) competition intensifies.

Looking out to FY23 (ending 3/31/24), we expect Anritsu to post JPY 75 of EPS, representing ~50% downside to Street. In our base case, we believe Anritsu will trade at 16.0x fwd EPS for a JPY 1,201 stock price at YE FY22 (ending 3/31/23; 33% gross downside). 

Company Overview

Originally dating back to 1895, Anritsu is a leading vendor of telecom-related testing equipment (along with U.S. peer - Keysight Technologies - and German peer - Rohde & Schwarz). It is based in Japan with global operations. Its business is comprised of three segments: Test & Measurement (“T&M”), Product Quality Assurance (PQA), and Other equipment.

Anritsu’s T&M segment is our area of focus and key to the short thesis. Anritsu derived 71% of its revenue and 85% of its EBIT from its Test & Measurement business in FY20, and T&M therefore drives the overall earnings picture. While PQA and Other’s EBIT has been ~stable through the years, T&M’s profitability has been quite volatile through the years:

Test & Measurement Overview

In the core T&M segment, Anritsu mainly develops testing equipment for:

·       Mobile communication (used in R&D and production of smartphones – makes sure smartphones connect properly to wireless networks, e.g., 4G and 5G)

·       Network infrastructure (analyzer for cell-towers/base stations – makes sure telecom radios are performing properly; datacenter connectivity evaluation tools – makes sure optical wires in datacenters are up to spec)

·       Electronics (general purpose measuring equipment for a variety of use-cases)

Within T&M, the mobile business is our focus given it: 1) represents ~59% of T&M sales and a higher fraction of profitability (not disclosed, but we believe 80%+) and 2) is the cyclical subsegment of the group (with network infrastructure and electronics ~ flat over time). 

Thesis

1) Anritsu is enjoying elevated profitability due to a product upgrade cycle that we believe is currently peaking.

2) Anritsu’s share in the current cycle is less than the prior cycle.

3) Testing equipment for R&D purposes are higher margin and we expect will be the first to decline, leading to mix-shift driven margin degradation over the next couple of years.

Thesis Point 1) Anritsu is enjoying elevated profitability due to a product upgrade cycle that we believe is currently peaking

Anritsu’s T&M segment operating margin has gone from 3.4% at the trough of the last T&M cycle in FY17 to 23.7% in FY20. Along with top-line growth, this has led to T&M EBIT 10x’ing over this time-frame. Since FY17, this has led to a 5.5x in overall EPS for the Company and a 2.2x in the stock price. 

We believe this was driven by a product upgrade cycle for its T&M equipment that is now peaking. 

Wireless Test & Measurement Cycles Explained

Each major generation of wireless connectivity standards (e.g. 4G, 5G, etc.) requires upgrades in 1) smartphone hardware and 2) network infrastructure. This new hardware, in turn, requires new Test & Measurement (T&M) equipment for verifying network compatibility at both the R&D and production stages. These sudden capital equipment investment requirements create clear industry boom- busts around major wireless standard changes that last 2-3 years each. 

Below, we show Anritsu’s T&M revenue growth over the past two decades. Growth elevates for ~3 years proceeding the beginning of a new wireless standard upgrade cycle and declines thereafter.

The current 5G cycle is developing similarly. 

Stages of Communication T&M Upgrade Cycle

The wireless-standard upgrade cycle takes place over two main stages of investment: 

R&D 

1) Chipset vendors (e.g. Qualcomm) must first design the new wireless chips (e.g. 4G, 5G “basebands”). 

2) Next, Smartphone OEMs (e.g. Apple) take the next- gen wireless chips, integrate them into prototype smartphones, and test the overall design with their own T&M equipment. 

3) Once the prototype phones are complete, telco carriers (e.g. AT&T) independently test and verify the prototypes with their own T&M equipment. 

Production

4) Once the final smartphone models are developed, manufacturing lines are set up for mass production. Manufacturing companies like Foxconn would need to make new purchases of T&M equipment to support basic wireless testing on the production line. 

When each step is performed for the first time, purchase of T&M equipment supporting the latest wireless standard is required. As T&M equipment have long useful lives (~7 years), these are one-time purchases in nature and create upgrade “cycles” of investment. 

5G Upgrade Cycle Detailed 

For developing smartphones with 5G compatibility, just like prior cycles, three separate R&D steps are taken: A) chipset development, B) smartphone development, and C) carrier acceptance. Finally, test systems are used in the D) production stage. 

We believe 5G chipset R&D peaked in 2020 while smartphone R&D and carrier acceptance are currently peaking. Meanwhile, we believe T&M for production will peak over the next 12 months:

A) We believe Chipset R&D has already peaked

Chipset R&D began in 2H18 and final products shipped to smartphone OEMs for R&D over the ensuing 12-18 months. Therefore, all major chipset makers have already researched and produced a new 5G chip. As such, there should be limited incremental demand for new T&M equipment here. 

We see this playing out in Anritsu’s own commentary: 

·       CY1Q19: “acquired early development demand of the 5G chipsets and devices” 

·       CY3Q19: “Currently, main demand is for the development-related measurement for chipsets and terminals compatible with [5G]” 

·       CY4Q20: “Demand for the development of 5G chipsets ... has been steady” 

We take this to mean chipset demand has peaked. We believe CY20 was the peak for chipset R&D. 

Importantly, the number of 5G chipset manufacturers is limited compared with smartphone manufacturers. Qualcomm, HiSilicon, and Mediatek dominate the market (combined ~3/4ths of the market). 

B) We believe Smartphone R&D is peaking

For smartphone R&D, we surmise that the number of smartphone vendors and models brought to market drives growth for T&M equipment. That is, new 5G vendors provide incremental TAM for Anritsu’s tools. Additionally, existing 5G vendors that increase the number of models brought to market likely also provide incremental TAM (more development required). 

On both accounts, 2021 is shaping up to be a peak year (delta in new 5G models produced in 2021 is lower than 2020; same goes for the delta in new 5G smartphone vendors): 

We believe CY 1H21 was the peak for Smartphone R&D. 

C) We believe Final Carrier Test Is Peaking

We believe final carrier test follows smartphone R&D with only a slight lag (3-6 months). That is, carriers need to be ready to evaluate new 5G smartphone prototypes from the smartphone OEMs. As a flood of new 5G smartphone prototypes hit the market in 2019 and 2020, carriers should have invested in capacity to test final prototypes commensurately. 

As we (a) believe T&M purchases for smartphone R&D peaked in CY 1H21 and (b) expect T&M equipment for production to be peaking in 2H21/1H22, this would argue for a ~6-month lag between smartphone R&D and final carrier-test peak T&M purchases. 

Final Carrier Test related T&M purchases are likely to peak in CY 2H21. 

With chipset and smartphone R&D past their peaks, CY 2H21 is likely to see overall R&D T&M sales step- down (as carrier test is unlikely to offset declining chipset and smartphone R&D related purchases). 

D) We expect 2022 to be the peak for 5G incremental production 

While 5G smartphone units are expected to continue to grow, the rate of change will decline slightly in 2022 and severely in 2023 (151mm units; 42% lower y/y), based on estimates from IDC. This means a smaller amount of new T&M units will be required at manufacturers: