Description

Company Overview

Keysight Technologies, Inc. (KEYS) is an international global electronic measurement technology company. Recently spun out of Agilent Technologies, Keysight targets 3 distinct markets: communications, aerospace defense & industrial, computers and semiconductors. The $4bn communications market includes network equipment manufacturers (NEMs) that utilize Keysight’s test and measurement instruments & solutions for development, production and installation of cellular and wireless equipment. In the $3bn aerospace defense market, Keysight offers measurement technology and solutions for radar testing, military communications & satellites. Finally, the $5bn industrial, computer & semiconductors market targets components, specific devices, interconnection, and RF & microwave design.

Brief History 

Keysight’s top market share products date back to HP’s incorporation in 1939. Divested in 2000, Agilent consisted of HP’s legacy measurements, components, chemical analysis & medical business. With pockets of growth emerging in Keysight’s seemingly mature market segments, Keysight will now be able to invest in strengthening its product suite and refortifying its moat.

More recently, Keysight acquired Anite, a UK wireless test and measurement solutions company focused on software and wireless R&D for $606m (8.1x 2016E EBITDA). Both software and wireless R&D exposure build on Keysight’s key growth initiatives and will help Keysight compete with communications companies such as Anritsu and Rohde & Schwarz. This acquisition is estimated to be ~$0.15 accretive to 2016 earnings and helps Keysight utilizes its significant offshore cash balance (80% of cash offshore based on the last quarter).

Investment Thesis 

Though much of the street disregards Keysight as a semiconductor company, we believe Keysight offers top market share in highly specialized products that are very cash generative, albeit with low growth. Keysight also has a portfolio of smaller offerings that the market will find attractive as it becomes a larger part of the company’s revenue mix.

Strong Gross Margins / ROIC Profile: Keysight is often written off as a highly cyclical business. Though top-line orders are susceptible to market cyclicality, Keysight was able to maintain a high gross margin profile (mid-50s) during the stress years of 08/09, specifically because of management’s aggressive drive to convert fixed-costs into variable-costs. Furthermore, Keysight’s ROIC is actually much higher than Agilent’s life science, diagnostics & applied markets (LD&A) segments – 31% vs. 11%. In turn, Keysight is very cash generative, requiring little cash to grow the business.

Renewed R&D Focus: Agilent’s Electronic Measurement business was utilized as a cash cow to invest in the faster growing diagnostic and genomics segment. In a management call, Agilent’s CEO Bill Sullivan stated: “We have capitalized on EMG since 2005 to build LDA into a sizeable and highly competitive business” & “the EM Company will be able to devote resources for its own growth that had previously been used to capitalize LDA.” On page 130 of the 12B it says: “The separation will permit each company to concentrate its financial resources solely on its own operations without having to compete which each other for investment capital. On page 48, “Wireless R&D spending remained soft reflecting a cautious spending environment though long-term industry fundamentals remain intact, with continued interest in high data rate applications such as long-term evolution (LTE).” I do not believe this is congruous with management’s stated 4-6% long-term growth rate in the communications market. Furthermore, Keysight lost a $250m contract with Apple in handset testing due to underinvestment pre-spin. I believe that investor fear over this contract loss will dissipate as the standalone business capitalizes on its renewed R&D focus.

Incentivized Management Team: Investing in Keysight is investing with management. A November 10th statement states that the CEO, Ronald S Nersesian, “now owns 386k common stock.” Not including the incentive package that focuses on shareholder value and ROIC, this ~$12mn speaks volumes of management’s confidence in Keysight’s future.

Spin-Off Dynamics: 1) Finding information on Keysight’s standalone business proposition is difficult. 2) Dividend investors may not be satisfied with Keysight’s lack of payout. 3) Underwhelming cost-cutting initiative has re-rated the stock to its spin-off price.

Growth Opportunities

Modular Instrumentation: Modular solutions combine instruments from various suppliers into one, comprehensive test system for customers. Currently, modular instruments have captured 10% of the automated test market, but are growing at 20% per year. Industry specialists believe that “besides the uptake in wireless communications… the global PXI market will [have] new programs in aerospace and defense and integration of wireless technologies in the industrial industries.”

LTE / 5G: Though a major player in LTE deployment, Keysight is greasing the wheels to become a dominating force in the 5G discussion. Keysight introduced in October the industry-first 5G Baseband Exploration Library, formalizing a community that will pay dividends as we approach the 2020.

Software: As an increasing percentage of T&M functionality is delivered through software solutions, Keysight aims to monetize its base of productivity tools as stand-alone packages. These sales require minimal COGS and SG&A and have high incremental profitability.

Risks

Cyclical product offering; geopolitical risk; lack of track-record as a standalone company; core offerings are GDP growth stories.

Takeaway

We believe Keysight is worth 15x consensus 2016E EPS of ~$2.50 ~ $37.50/share (25% upside).  Our ultimate view is that this is a highly cash generative business with reasonable downside protection.  Small pockets of organic growth offer an ability to grow earnings with limited capital intensity and cash flow yield is significantly above market.  While this is a modestly-sized position, we think it serves a good role in the portfolio.

Catalyst

(1) Capital return - holder base rotation toward yield oriented investors;

(2) Currency headwinds abate.