Description

IDEA

Sporton with HQ and listing in Taiwan is one of the few global companies providing complete inspection and certification services for IT products. It has strong international certification capability with leading inspection technology, making it the market leader in smartphone and wireless communication testing. The company expects its revenues and operating margins to grow substantially as a result of the introduction of 5G, similar to what happened with 4G during the period 2013-15. With improvements in technology, testing and inspection becomes more complex. This allows Sporton to increase prices and improve its profit margins. Recent capacity expansion came online in H2 of 2018 and should result in revenue growth in excess of 10% for the years 2019 and 2020. Over the medium- term management targets revenue growth of 8-10% p.a. and EBIT margins of 35%.

The share price has declined more than 40% since its peak in 2015 because of a decline of the number of smartphone models launched in anticipation of 5G and concerns over a slowdown in China & trade tariffs.

14x next year earnings, net of cash, is an attractive valuation for a market leader in an attractive niche with high ROE (>20%), high operating margins (27%) and good growth potential.

The CEO and Chairman, Mr. Huang, owns 27% of the shares and has created a lot of shareholder value over the years. He pays himself no salary and targets a dividend pay-out ratio of at least 70%.

BUSINESS

Every electronic device requires testing and inspection before it can be sold in the market. Initially, the Federal Communications Commission (FCC) tested all electronic devices sold in the US. When the market grew the FCC started to authorize labs to do the testing and certification. Sporton was founded in 1986 and was one of the first labs to be authorized by the FCC. Today, Sporton has the largest market share of US FCC filings for personal communication systems and is the only firm focused on this type of testing and certification. The main competitors are fairly small departments of much larger companies such as Bureau Veritas, SGS, UL and Intertek.New entrants face substantial barriers to entry.The testing industry is a capital and technology intensive industry that heavily relies on its engineers and other talents. There have been no new competitors entering this industry for a long time.

Source: Sporton Investor Presentation

Sporton generates 90% of its revenue as a leading test and certification service provider in wireless communication. The balance is sales of EMI (electromagnetic interference) shielding components which is complementary to the testing business. Testing and certification include mandatory and conformance testing services for electronic devices. Sporton is one of the few companies that are capable of providing both.  The main types of products tested are cellphones (~40% of revenue), networking products and IoT (~20%) and other products such as keyboards, monitors and mouses (~30%). The majority of sales are generated in Taiwan and China. Currently, 18% of sales come from the US and Europe. Sporton has more than 1000 customers and its largest client accounts for less than 5% of sales.

Mandatory testing services involve testing products against government standards on matters including electromagnetic compatibility (EMC), safety, specific absorption rate (SAR) and radio frequency (RF). Conformance testing services involve testing products against standards set by telecom operators/carriers.

Electronic devices will always need testing and certification services for EMC and safety as long as electromagnetic interference (EMI) exists. EMI is caused by the electric- and magnetic field created during the use of electronic devices.

Safety tests are required for electronic devices because of risks such as electric shocks, energy hazards, fire, mechanical and heat hazards, radiation hazards and chemical hazards.

Specific absorption rate (SAR) testing is a mandatory test because of regulation regarding the rate at which energy is absorbed by the human body when exposed to radiofrequency (RF) energy.

Sporton sees itself as the premium testing service provider with a 6 months technology lead over its competitors as a result of several factors such as:

• Sporton is the only company focused on this business and competes with departments of much larger organisations with a different focus

• Sporton participates in the Standard Setting Committees

• They developed a close cooperation with Qualcomm on the specifications of the new chips giving Sporton a head-start when they start discussions with smartphone manufacturers.

• Sporton is one of the few companies with the experience and expertise to pinpoint the exact reasons for prototype failures and the ability to offer solutions.

• Sporton can offer tailor-made EMI components.  Its competitors cannot.

• Sporton has the capacity in Asia to conduct testing in a very short period and is able to conduct multiple tests simultaneously.

When large customers make a flagship product, like the Huawei P10, they typically rely on Sporton to do the testing because they know Sporton has the experience and expertise, can offer EMI components and is able to guarantee fast turn-around times.

Sporton does the testing for most of Huawei’s high-end and middle-end phones (60%-70% of Huawei’s phones) while its low-end to middle-end phones are tested by BV or SGS.

Sporton has 8 service locations in Taiwan, 3 in China and they recently opened 1 in the US. Lab utilization is high with 50% of the labs in Taiwan and 30% in China running 24/7 on 3 shifts and the rest on 16 hours per day on 2 shifts. Most of the manufacturing of electronic devices takes place in China and Taiwan and Sporton’s service stations are located close to their clients’ factories and R&D departments. The main reason for setting up a US lab was that the US has become more protective about its technology.  A US lab allowed a cooperation with US clients in such a way that they’re comfortable that no confidential information will be leaked.

GROWTH

Sporton’s revenue is driven by the number of new devices that are brought to market and technological advances. When technology advances all the devices advance and testing and inspection needs to advance as well.

When technology evolved from 3G to 4G, the regulation and the testing and certification procedure changed. Sporton was able to raise its prices by 30% to 40% because the testing is more complicated. Revenue increased with 20% in 2013 and 27% in 2014. The technology is now evolving from 4G to 5G.

5G is expected to drive revenue growth in 2020 and 2021, similar to the impact of 4G in 2013 and 2014. The technology in 5G products (26 GHz - 30 GHz) is much more advanced than for 4G products (3.5GHz - 6GHz). Therefore, Sporton believes that the price increase for its services will be higher than with the introduction of 4G. This price increase will boost revenue and gross profit margins significantly.

5G technology is likely to support the growth of IoT, which is currently still a small percentage of revenue. When the number of IoT devices increases the addressable market for Sporton grows.

Sporton is expanding its business for smart cars. In its Kunshan plant, Sporton had introduced a new team focused on IT devices in automobiles. The capacity of the Kunshan plant was expanded by 100% and comes online in the 2ndhalf of 2018.

To increase its market share in the US, Sporton set-up a lab in San Jose to be close to the many IoT startups. The lab will initially focus on its phone testing business. At a later stage, it will develop the IoT testing business. This lab will start operations during the 2ndhalf of 2018 and is expected to be break-even in 2020.

Management expects revenue growth of 8-10% p.a. over the medium term. The capacity increase that came online in H2 2018 should further boost revenue growth to over 10% for 2019 and 2020.

OPERATING MARGINS

LTM the operating margin was 27%. Gross margins are highest for the phone testing business at >50%, 40-50%

forother devices and 20-30% for EMI components.

The margins in Taiwan are higher, 50%+, since the small geographical area allows each lab to specialize in certain tests. The margins for the labs in China are lower, 43%, because each lab offers a range of different testing services.  

As the number of different products that require testing and certification increases because of 5G and the price of testing this more complex technology increases, Sporton believes its operating margin can improve to 35%.

CAPEX

Historically, the capex has been on average USD 11mio per year. In 2018, the capital expenditure is estimated at USD15/16 mio because the company is building a new lab in the US and is investing in the testing service for cars. In 2019, the capex is expected to increase to USD18 million dollars because the firm will equip many of its labs for 5G testing.

VALUATION

The share price has declined more than 40% since its peak in 2015 because of a decline of the number of smartphone models launched in anticipation of 5G and concerns over a slowdown in China & trade tariffs.

The shares trade at 14X 2019 earnings, net of cash. The dividend yield is 5%. At this valuation, we do not need the company to reach management’s targets to achieve an attractive return.

Over the last 5 and 10 year revenue grew at approx. 10% p.a. with average operating margins of 29% versus 27% currently. Revenue growth has been achieved organically without financial debt and with a high average L10Y dividend pay-out ratio of 74%.

Based on the capacity expansion and the expected impact of 5G it seems that the historical performance can continue for the medium term.

MANAGEMENT

The CEO and Chairman, Mr Huang, owns 27,17% of Sporton and he takes no salary.

In 2017 the total compensation for the Board of Directors was USD 96,000 and USD 800,000 for the management team.

Judging by the offices we visited in Taiwan, frugality is not limited to senior management compensation.

The management has created a lot of value for all shareholders with its focus on being the best in a niche activity.

Today, Sporton has the largest market share and is the only testing firm that participates in the 5G Standard Setting Committee and has a close cooperation with Qualcomm to develop the testing technology for 5G. The company seems well positioned to maintain its market leadership over the medium term.

The company has not made any acquisitions in the past and does not expect this to change going forward. Combined with a high dividend pay-out ratio the capital allocation risk is low.

RISKS

• When technologies mature, for example 4G today, revenue can decline as the growth in ASP and the number of new models slows down.

• 5G may take off later than expected or mature earlier than 4G did. When the cycle for new technologies shortens, the period of growth for Sporton might shorten too.

• Sporton might not be successful in growing its IoT business.

• The trade war could intensify. In 2018 sales to China dropped from 23% to 18% because the US banned sales to ZTE. ZTE accounted for 2,5% with the other 2,5% coming from a decline of other Chinese orders.

• Sporton’s largest competitors could become more aggressive in its efforts to gain market share.

• Sporton is responsible for employees’ violation of confidentiality agreements. Sporton has strict processes to ensure that only employees involved in the testing of a certain prototype have access to confidential information. However, the risk of leaks always exists.

Catalyst

- 5G, IoT & Smart Cars
- Capacity expansion in US and China