Harmon International is the world leader in design and manufacture of auto dashboard infotainment systems with 22% share, twice their nearest competitor. Auto-related sales are ~73% of revenue. Remaining revenues are derived mainly from professional level recording and performance audio equipment.

Though the company operates predominantly within a cyclical industry, the company is benefiting from two factors. First, is the secular growth of dashboard infotainment as the systems penetrate beyond their luxury auto roots into sub luxury autos. Current penetration of infotainment systems in global auto production stands at around 20%. Thus Harman sales should grow faster than the overall auto market for year to come. (The company believes penetration can reach ~80%)

Second, the company will also benefit from margin improvement thanks to changes made by the new CEO, Danesh Paliwal. He's cut costs across the board, but even more important he's changed the business model from designing a customized infotainment system for each auto to designing off a scalable platform. FY2012(Jun) is the first year higher margin scalable platform backlog is entering into production/revenues and as it builds up it should drive improving margins for the next three to four years.

Based on company backlog, a stable auto industry (i.e., no recession), earnings and margins are on track to grow as follows:

Because it is perceived as a technology company within the auto sector the company gets a premium multiple (a la GNTX and BWA). Focusing on valuation since the bottom in 2009 and since EBITDA recovered post crisis, the stock has traded between 7x and 11x EV/EBITDA.

Based on my estimates for FY2013 (ending June 2013) and a the low-end historical 7x EV/EBITDA, I see fair value for the stock around $65.75 or 39% above the recent price of $47.25. Harmon’s enterprise value as of December 31^st, 2011 is as follows:

As of FY2011(Jun), revenue and operating income break down as follows:

Harmon is the share leader for dashboard infotainment at ~22%, twice its nearest competitor.

The business is driven by contract wins with auto OEMs and specifically the amount of revenue in backlog and the margins contained within the backlog.

Danesh Paliwal, the new CEO since 2009 has rebuilt the business from the ground up and while he has certainly benefited from a rebound in worldwide auto SAAR since the bottom in 2009, he has made important changes including cutting costs, moving production to lower cost countries, moving to a scalable platform, and properly pricing business at the time of bidding. While the rebound in auto sales and the cost cutting impacted the bottom line immediately, the benefits of the scalable platform and properly priced contract bidding take years to flow through to revenues as business bid today can take years before it gets into actual production.

The best of this backlog, that which is based off the scalable platform and with operating margins in the range of 8% to 10% is just beginning to hit revenues in FY12(Jun). The table below details the likely flow of scalable backlog into Infotainment Segment revenues over coming years.

Using trailing run rate revenue at Dec 2012, each  additional percentage gain in operating margin

RISKS

A recession in auto sales is the most obvious risk. Next would be a significant drop in European auto sales beyond that already assumed. However, do not be fooled by the company’s high European/German revenue as the company’s actual SAAR into Europe is ~35%. (Company does not report breakdown of SAAR, but it is available from IR if asked. They have an excellent IR with a fellow who has a consulting background and undestands how to help the buyside.)

Another risk as outlined by a recent sellside initiation is that smartphones/tablets will take over as the “brain” of the auto infotainment center. However, it can’t happen any time soon.  The auto infotainment system is critical to operating the car. It has to control half a dozen apps at the same time to direct HVAC/entertainment/back up radar, etc, etc. and at high speeds, extreme conditions, etc, and without fail. Smartphone apps are always crashing and can't do this.  Also, what if you get out of your car and you lose your phone, your phone is stolen, or you drop and break your phone? Now what? And what if its negative 20F outside or 110F and your stranded or can’t get the heat or a/c working. Etc, etc. Smartphones are not an issue.