Description

Investment Thesis:  Gemalto NV (GTO FP)  formed this year from the merger of two leaders has a 45%-50% market share in the niche ‘smart card’ technology sector. A tough year in 2006, the industry consolidation, and  technology evolution combine to create a value opportunity. Management’s 2009 ‘low teens’ EBIT margin targets imply an EBIT of 300mm Euros, or an EV/EBIT of 4.0x. 

Gemalto NV (GTO FP) is the largest provider of ‘smart cards’ and related security & authentication software to mobile phone carriers, credit card issuers and governments. It has pro-forma 2006 sales of EUR 1.7bn, 400mm in net cash, a market cap of EUR 1.7bn.    Gemalto has the leading technology portfolio for its sector, and important IP rights addressing data security and authentication across networks (i.e. SIM cards, secure credit cards, ePassports). 

The value opportunity exists mainly because 2006 pricing was terrible for SIM cards, as industry battled for position in emerging markets and ahead of a consolidation phase. Average selling prices (ASPs) for SIM cards fell over 30% in 2006, and sales were flat, as volume growth has offset the dramatic price drops. EBIT margins for Gemalto dropped from 7.5% in 2005 to slightly under 4% in 2006.

Management has indicated that synergies from the merger of Axalto and Gemplus (officially finalized last week) will result in over at least EUR 85 million savings – almost 5% improvement in margins.  Purchasing and R&D synergies are the biggest drivers. Chips represent 35% of costs, and Gemalto estimates they can get prices 15% to 20% lower than its competitors as a result of their scale. 

Personnel cost savings from the merger could also be significant. However, being French, and with 6,000 of its 11,000 employees in France, shedding employees will be a quiet process.  I expect the company to ‘quietly’ shed 5-10% of its workforce over the next year, more could come later.

While Gemalto does some manufacturing (mainly card printing) it is not capital intensive  and is primarily a software driven business. Capex & D&A are each 3.5% of sales, while 7% of sales are spent on R&D. Smart card making involves buying a chip (from Infineon, NXP, STM, Renessas, LG),  adding encryption, authentication and networking software and  packaging it in various formats for SIM cards, credit cards,  IDs or security tokens.  The key value added and barriers to entry is in the software and in the customer relationships. 

The ‘smart card’ industry is surprisingly concentrated in Europe, where it has its roots as result of more banking and security encryption companies and earlier GSM mobile phone networks.  GEMALTO is the undisputed leader in the industry, with 45-50% market share.  Industry consolidation is likely to continue, as there are still too many sub-scale players, market shares of the top 5 players shown below:

Company                      Mkt Share         Home Country         

                        Gemalto                       45%    Public, French

                        Oberthur                      12%    Public, French

                        GND Card                   10%    Private, German

                        Eastman                       6%       Chinese

                        Orka                            5%       French (subsidiary of Safran)

2006 sales by end markets are 60% for mobile communications, 23% for financial transactions, 13 % for identity and security, and 6% in other (terminals, public phones). 

Going forward, I expect sales to grow at 10% p.a. (not withstanding pricing pressure of 10-15%).  The fastest growth to come from the identity and security sector as projects like implementing e-Passports and health cards take off worldwide. Gross margins are highest for mobile phones 33% and ID cards 30% and lower for financial cards at 20%.  

Mobile phones (60% sales):

In 2006, GTO will have sold around 1bn SIM cards, at ASPs of around 1EUR. SIM cards are a small and cheap device that plays an important role in security and authentication, a role that is increasingly important as phones become data portals.  

Volumes are driven by an installed base of  2.5 billion handsets which should grow overtime, and the continued replacement of cards from pre-paid customers and churn.

Volume growth for SIM cards should continue at a more moderate 15-20% a year, while we expect ASP price declines to also slow to 10% pa.  

Gemalto sells to all 400+ mobile phone operators. Phone carriers (Vodafone, China Mobile, etc) typically work with 3 to 5 SIM card vendors.  Mobile carriers bid out 3 month to 1 year contracts for new cards with specific requirements.  The commoditization of SIM cards is a constant threat, but less so to the technology leader with the best purchasing terms.

The low end of SIM cards has become a pure commodity, with no supplier pricing power. Cards sold in new low end markets like India, are the most basic 16K-32K 2G SIM cards are offered for under $0.50cents in periodic e-auctions. Gemalto has remained an important player in these fast growth markets, in spite of their low profitability with the hope that clients will migrate to higher end cards with more protected IP.  

The pace of adoption of higher end SIM cards (e.g. USIM 3G cards, cards with higher security features, and more memory) has been somewhat disappointing. The key driver for adoption is the development of more services over mobile phones, a trend that is taking hold with 3G in Europe and in China, and consumer acceptance of multi-purpose phones..

A roadblock to SIM cards taking over more of the functions of the handset has been that the communication protocol from SIM Card to phone terminals is outdated. This may change soon. There has no use for operators to buy high memory SIM cards as the pipe into the phone is a narrow straw. The likely  adoption in H1 2007 of the USB standard for SIM to mobile handset communications will enable SIM’s with larger memory (e.g. 32MB, 64MB+) and increased functionality – making it easier and faster to upload (Over-the-Air)  multimedia products and offer secure e-wallets mobile phone payments, and ultimately video on demand.

If mobile operators and card makers have their way, the adoption of new standards will give new life to this industry.  From 2008 onwards, Gemalto will benefit from a new generation of USB protocol based SIM cards and handsets and from licensing revenues, as it also happens to own significant IP on this preferred new standard.

Finance cards (23% sales)     

This segment is experiencing good growth prospects, especially in the US, and has more margin visibility as contracts in banking sector tend to be 3 years long.  Financial clients require significant trust and a close cooperation with ‘smartcard’ makers’ as they share important client information and personalization data. The adoption of new security standards  (EMV, SEPA, etc.) is a driving growth in this sector, as well as increased penetration of new technologies, like contactless payment. This segment has good visibility, and decent margins.

Unlike in Europe, US banks seemed to shun having cards with ‘chin and pin’ technology until very recently. In 2006, the US has begun adopting a new technology ‘Paypass’ for contactless payment with credit cards.  Early trials in NYC have been well received, and Gemalto expects strong volumes in the US, and other countries who will follow. Master Card and VISA see contactless payments as an important driver in substituting cash used in small transactions (e.g. McDs, public transport).  Volumes of cards with chips sold are growing rapidly.  This trend should be sustainable and defensible.

The security of credit cards with chips can be surprisingly high, and can lead to lower credit card fraud as a result of highly secure protocols such as dynamic security codes and encrypted account numbers. 

ID & Security cards (13% sales)

This industry segment requires being present in home markets, as governments and coprorates tend to trust domestic suppliers. Gemalto’s global presence and R&D in this sector is starting to pay off as post 9-11 there has been a strong trend for higher use of secure ID’s. 

The US government will be issuing e-Passports starting in 2007. These will be supplied by Gemalto and by Infineon (a rare occasion where IFX competes directly with GTO).  Passports will have chips loaded with encrypted biometric and passenger information that will facilitate border crossings and improve border security. Counterfeiting passports will be nearly impossible.  Other countries will have to follow shortly.  This new business has 10 year + visibility, and has a high element of service and recurring revenues. I expect this segment to grow at 2-3x the rate of the company over the next 3 years.

Gemalto has indicated that the margins at the early stage of e-passports deployments are very low and should improve as these grow in scale and in service revenues.

Summary Valuation and Estimates

Fair value for GTO.FP is between 1.0x to 1.5x 2007 sales, or  25 to 33 EUR, a 30% to 70%  upside potential.  This translates to EV/EBIT in 2009 of 6x to 8.5x, taking managements margin guidance, reflected in our forecasts below. 

EV/Sales            =  0.75x       19   spot price

Target EV/Sales =  1.0x  è  25  merger syergies target

                                1.5    è 33   w/ technology bet target      

The downside scenario is that the market for smart cards remains difficult longer, and the management fails to capture the expected merger synergies and technology opportunities.  In this case, the company deserve to trade back down at 15 EUR, 8 to 10x an EBIT of 100 to 130, or EV/Sales of 0.55x

RISKS

• There is a technology bet involved here especially in SIM cards.
• Management margin targets are clear, yet a clear path to achieving them has not been outlined. Margin improvements may not materialize until 2H 2007 early 2008.
• TPG and Quant family own 14% and 10%, respectively and have no lock up. TPG’s investment dates from 2001, so they may decide to exit in the next couple years.
• Merger involves risks of losing key people and restructuring costs have not yet been quantified yet by the company.

Key Dates

Feb 2007, 4Q results

H1 2007 expected announcement of USB SIM standard adoption

Related Securities

Oberthur SA
ST Micro (owns IM Card)

Safran S.A (owns Orga)

Infineon 

Catalysts

Contract wins (e.g. Passports, bank cards)

New product introductions, technology standards

Share buyback (up to 10% capital), started end of November 2006

Catalyst