| 2018 | 2019 | ||||||
| Price: | 13.35 | EPS | 1.95 | 2.30 | |||
| Shares Out. (in M): | 109 | P/E | 0 | 0 | |||
| Market Cap (in $M): | 1,455 | P/FCF | 0 | 0 | |||
| Net Debt (in $M): | 1,508 | EBIT | 310 | 360 | |||
| TEV (in $M): | 2,963 | TEV/EBIT | 0 | 0 | |||
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Thesis / Idea Summary
Conceptually, TTMI is a play on consensus estimates being too low as a result of a combination of mismodeling by sell-side analysts and underappreciation for the context of the company’s recent financial history and results. There are multiple levers for management to pull in order to create value over time, but the primary “juice” of the thesis will come from revisions to consensus estimates as sell-side models are adjusted to compensate for currently overlooked tailwinds. I expect these revisions to take place in the latter half of 2018 and into 2019.
TTMI makes printed circuit boards, which are typically low-tech, but high-volume, and fundamental to anything with an electrical circuit, more or less. In a heavily fractured field, TTMI is one of the largest and most globally-competent, thus maintaining a long-standing trusted supplier status with the largest OEMs out there.
I view this idea as having significant upside, mostly due to the degree to which I believe consensus is too low (~15-20%, maybe more), which, along with a little comeback on the multiple that hopefully comes with it (from hopefully a better economic FUD environment and a return to TTMI’s normal valuation range on some beat-and-raise qtrs). The biggest issue with the timing is that China and cyclicals-exposed component suppliers are getting killed right now based on the FUD-filled newswires and environment and there is near-term volatility and trading risk as a result. That said, 1) I’ve owned it for a while, so timing of entry for me is not a much of a focus; 2) the price has really fallen hard on the FUD going around without anything company-specific; 3) I think you’ll wake up in 2 years with a stock worth a lot more than it is today.
TTMI reports earnings tomorrow night (10/30), and the last time I did a post right into earnings (WEB), I got destroyed on the earnings. WEB worked out in the end, but duly noted the potentially dangerous idea of pitching into a qtr, especially in this environment. By all means wait for the qtr to pass - I’m somewhat making a call on the qtr (particularly the GM% line, more so than revs), but there’s enough room here to get in after too.
Company Description / What They Do / Background
TTMI manufactures and sells printed circuit boards (PCBs), in addition to a small contract manufacturing business (~8% of rev). Following the acquisition of Anaren (announced Dec 2017, closed April 2018, from Veritas Capital for $775M), TTMI now also provides RF subsystems, which are modules integrating multiple RF components, used in larger RF-focused equipment (think military radar systems, radar-based safety mechanisms in cars, or telecom base stations). Anaren represents an adjacency - as opposed to a consolidation - given that RF subsystems are full modules, not just the PCB, which are higher-IP / more highly-engineered products (read: higher GM%).
PCBs (still >80% of rev including Anaren) are the fundamental building block of all electrical devices, as they are the base/substrate on which electrical components are attached (e.g., semiconductors, etc.). For those less technically inclined, its that flat green board you see if you ever open up any electrical device. The PCB market is both large and fractured at roughly ~$55B overall, but with TTMI in second position with only 5% share. Each of the larger players have their own angle or special sauce, TTMI’s being rigid PCBs (top share), as well as global reach and resources, which most other players don’t have.
TTMI sells largely to OEMs, whether directly or by way of contract manufacturers, across multiple end-markets. TTMI’s customers include AAPL (~15% of rev), CSCO, NOK, Huawei, Raytheon, Bosch, Autoliv, and Tesla, among others. While there is some degree of customer concentration (e.g., AAPL), from an end-market perspective, TTMI is highly diversified, operating across aerospace/defense, automotive, cellular, hardware/peripherals, medical/industrial instruments, and networking/communications, with no end-market larger than 20% nor smaller than 14% of rev.
TTMI has pursued a consolidation strategy over time, with the most recent PCB deal of size being the 2015 acquisition of Via Systems, which was not only highly successful from a deal synergy perspective, but also helped TTMI’s end-market diversification significantly, while shrinking top-5 customers to ~33% of rev (from ~50% previously).
The revenue synergy to TTMI from Anaren comes from TTMI’s existing expertise in 1) creating specialty PCBs for RF applications; and 2) TTMI strong exposure to similar customers in aerospace/defense, auto, and networking/comms. Anaren further diversifies TTMI, while adding exposure to fast-growing A&D markets (end markets are 70% A&D / 30% communications) and materially improving TTMI’s growth rate and margins.
As one might expect, TTMI’s rev growth starts at unit growth of its end markets, with some further step up from content growth (e.g., auto, A&D, medical, industrial), as well as pricing (advanced PCBs in cellular and compute). Further, fairly intuitively, this is a low GM% / low opex business, where fab utilization is important, every 10 bps of GM% has a material impact on bottom-line, and opex is mostly fixed. As a result, beyond rev growth and below-the-line stuff, earnings will grow on operating leverage and any and all GM% gains that can be eked out from manufacturing efficiencies and/or mix.
Key Thesis Points / Why This Opportunity Exists
The crux of the thesis is that consensus is way too low on 2019 and beyond, based on missing 2 important GM% factors, thus significantly mis-modeling earnings. There are other positives to consider as well, but in terms of what will drive the majority of the alpha here, it’s the huge GM% whiff.
I’ll start with some numbers to set the context.
TTMI’s PCB GM% for 2015-2017 was 15.5%, 17.7%, and 17.2%. The contract manufacturing piece is very small and has minimal impact - typically runs GM% in the HSD range. When Anaren was last public - last reported qtr was 4Q13 - GM% was in the 36-37% range.
Overall, TTMI’s GM% for 2015-17 was 15.6%, 16.8%, and 16.2%, with consensus for 2018-20E at 16.7%, 17.5% and 17.6%, respectively.
Depending on how you model Anaren, it comes out that consensus implying standalone TTMI GM% anywhere from 14.8-15.0% for 2018 and 15.0-15.5% for 2019, with bottom-end of both of those ranges the most likely implied number. In terms of “depending how you model Anaren”, I’m running the exercise as them doing anything from ~$250M in annual revs at 37% GM% (my assumptions prior to deal-close) to ~$280M annually at 43% GM% (more likely assumption post-close, based on Q2 results).
What we are left with is the assumption from the Street that 2018 standalone TTMI GM% declines >100 bps, before recovering and growing 20-50 bps in 2019. Keep in mind, adjusting for cost reclassifications (see below) that would lower GM% by ~75 bps (no impact to EBIT%) prior to 2017, that standalone assumption for 2019 is still (well) below 2016 and not much better than 2015, which would be curious given the margin improvements post-Via Systems and other general improvements in the business (operating leverage on growth, better mix).
GM% Factor 1 - Cellular Bounce-Back
Starting 2Q17, TTMI’s GM% took a huge dive, falling 190 bps y/y in 2Q17, 250 bps in 3Q17, 100 bps in 4Q17, and 350 bps in 1Q18 (down <75 bps in 2Q18). For 2-4Q17, part of the impact was from a reclassification of ~$5M/qtr in costs from G&A to COGS, which accounts for ~70-80 bps of the decline in each of those qtrs, though obviously there is something else causing majority of those declines.
That “something else” was largely AAPL. 2017’s iPhone models - particularly the iPhone X - had numerous supply chain issues and delays (widely reported), culminating in the iPhone X getting released in November, well after the release of the 8 and 8-plus in late September and later than any other iPhone release in history. The timing is important - PCBs are one of the last items ordered prior to assembly (given lower levels of complexity relative to other components) and PCB margins are highly sensitive to fab utilization levels. This is particularly true for TTMI’s advanced PCBs, which are really only sold into AAPL and some PC manufacturers (but mostly AAPL). Thus, the later-than-normal iPhone cycle threw off utilization levels in TTMI’s advanced PCB fab relative to normal, killing GM% comparisons with the prior year. This was further compounded by weakness in iPhone sales relative to expectations.
Quick side note on iPhone sales vs. expectations - don’t confuse AAPL beating consensus on iPhone with what AAPL and AAPL’s suppliers were actually expecting originally. AAPL ended up exceeding expectations after everyone lowered numbers already. Units have barely grown over the last several qtrs and supply chain expectations were much higher than what came to pass - there were numerous media reports about this, in addition to suppliers missing earnings all over the place in the Dec and Mar qtrs. Plus, AAPL noted on its March earnings call that there was a significant reduction in channel inventory. Bottom line - supply chain was expecting much better unit demand than what came to pass, based on AAPL’s own direction to their suppliers.
TTMI mgmt has noted that a similar dynamic took place in 2014, where the iPhone 6 release in late September - though not far off from normal iPhone release dates - ended up producing a later-than-normal iPhone demand cycle “start date”, pushing peak demand out just enough to throw off TTMI’s normal utilization cadence. Fortunately, iPhone cycles effectively reset every year and the release date of one year’s model doesn’t really impact the release date of the following year’s model, nor does it materially alter seasonality going forward (i.e., abnormal iPhone cycle timing doesn’t reverberate on TTMI’s financials beyond the sales cycle for that given model).
Which brings us to 2018/2019. The 2018 iPhone cycle has been progressing on a more normalized timeline, from supply chain to release dates. While TTMI mgmt won’t explicitly come out and say “margins are going to be a lot better”, they have noted there hasn’t been any disruptions to the supply timeline like last year, on top of general comments in the past that a normal timeline would normalize GM% in that area of the business (and for the company as a whole). Q3 brings the first clean lapped qtr - comps should be extremely easy given benefit of full qtr of iPhone ramp (vs partial ramp last year), on top of better matching of expectations to demand (reports on iPhone demand have been positive thus far), and no adverse comparison on the G&A-to-COGS reclassification. I’ll also point out that TTMI’s tgt EBIT% prior to the Anaren deal was 10%, which mgmt has said would’ve been accomplished already if not for the 2017 AAPL situation, meaning a normal AAPL cycle, combined with other gains in other aspects of the business, would yield >10% EBIT% on an LTM ex-Anaren basis, or ~100 bps higher.
The bottom line is, my view - somewhat confirmed (certainly not disputed) in conversations w/ mgmt - is that - ceteris paribus - standalone TTMI margins should revert back to 2016 levels, less ~75 bps or so due to the G&A-to-COGS reclassification. As I noted above, 2019 standalone TTMI GM% is being implied to be somewhere between 15.0-15.5%. 2016 GM% was 16.8%; if I shave off 75 bps, TTMI should be generating GM% somewhere in the 16% range, before considering improvements in mix, operating leverage (standalone TTMI rev in 2019 will be 15-20% higher than in 2016). My own estimates are for ~16.5% GM% for standalone TTMI. Remember, 100 bps to TTMI is a huge deal. Ex-Anaren, on no rev growth, 100 bps of GM% = 6-7% earnings delta; with rev growth its >10%.
I’ve asked the different sell-siders why this isn’t being considered in their numbers and the answers have typically been some combination of implicit admission of lazy modeling and not wanting to be a hero and being “conservative” on GM% expectations and leaving upside to numbers. Not an uncommon sell-side approach, but bottom line is that headline consensus is too low and the fairly fixed cost structure causes this mistake to cause a meaningful skew to bottom-line numbers.
GM% Factor 2 - Anaren Margin Profile
This point is somewhat tied to the first in that depending on what the Anaren assumptions are, the implicit TTMI assumptions are either somewhat off or wildly off. Put another way, consensus is either short-changing Anaren’s margin contribution or short-changing standalone TTMI GM%, or both. My guess is that its both, based on speaking with most of the sell-siders and going through their models line by line.
Anaren’s margin profile is meaningfully better than standalone TTMI, w/ GM% in the high-30s/low-40s and EBIT% in the low-20s+. This compares to mid/high-teens GM% and HSD-10% EBIT% for standalone TTMI. While Anaren will be ~10% of rev, it will represent >20% of profits, potentially >30%. Given that Anaren was once public before being taken private, and thus their prior financials are public, its quite puzzling to me how sell-side mis-modeled margins pro-forma for Anaren (or for the company as a whole). In fact, prior to the deal closing, I was assuming ~37% GM%, which was exceeded in their first qtr together (2Q18), with Anaren coming in at 43.3%. While this isn’t a “cost synergy-rich” deal, there are some cost savings (projected to be $15M), which would actually improve Anarens profits by ~20-25%. Moreover, mgmt has guided Anaren to HSD growth. It wouldn’t be a stretch to see Anaren contributing $300M in revs next year at 45% margin.
While its harder to tell now, before the deal closed, it was clear that consensus wasn’t modeling in Anaren’s GM% properly - 2018 and 2019 consensus GM% barely moved until they reported Q2 earnings, despite Anaren being fully included in sell-side models following Q1 earnings. Put another way, when Anaren was included in all sell-side models, it was mostly being folded in as added rev at corp avg GM%. This is what makes me believe that the GM% estimates are low on both factors - sell-side was too lazy to incorporate Anaren GM% despite publicly-available data and I’ll bet those models are being inched up by force, as opposed to a more informed approach. I’d guess that instead of breaking out Anaren separately, they are just doing an arbitrary inch-up of the GM% they had before. Certainly the sell-side models I saw didn’t have a separate Anaren breakout on the GM% line.
Other Positives of Note
Operating Leverage - TTMI’s opex spend is remarkably consistent on a dollar basis. Looking at 2016 and on (i.e., after the ViaSystems deal), qtrly opex was between $49-52M in each qtr of 2016 and $41-48M (with the $48M being more of an outlier) for every qtr of 2017, which makes sense given the reclassification I noted above. In Q1 and Q2 of 2018, it was $45M and $52M, though the $52M included Anaren. Rev is ~20% higher now than it was in 2016, nevertheless, opex has still be in the $45-55M range per qtr, before Anaren. Looking at Anaren’s prior public financials, they also exhibited a fairly fixed opex range on a qtrly and annual basis. On top of this, there are $15M of cost synergies expected to be pulled out of the deal. The operating leverage here is meaningful.
Strong FCF-gen / De-leveraging focus - TTMI’s capital allocation priorities are focused on de-leveraging, with target leverage of ~2.0x net. Debt load post-Anaren is $1.6B and they are currently running at $200M of cash on the BS, so $1.4B net. This equates to somewhere between $300-600M of debt reduction required to reach their goal ($600M if using LTM EBITDA of ~$400M; closer to $300M on what EBITDA should be in the next 18-24 months or so). Prior to Anaren, TTMI was throwing off >$200M annually in FCF at a margin of ~7.5-8.5% of revs. Back-of-the-envelope math on that yields $250-300M of annual FCF (given the substantially higher margins at Anaren, I assume at the very least TTMI hits FCF margins at high-end of normal ranges, if not raising the ceiling closer to 10% on ~$3B in revs). Bottom-line they should be able to hit target leverage in less than 2 years.
This provides 2 explicit benefits: 1) FCF improvement from debt reduction; and 2) BS flexibility for other capital uses (buyback, dividend, more M&A). On the first point, TTMI has 3 pieces of debt - $946M of floating rate TLs running L+250, $375M of HY running at 5 and ⅝, and $250M of converts at 1.75%. Forgetting the HY callablility for now, assuming they just go after the TL and assuming (for conservatism in this case) that the stated rate in the last 10Q of 4.6% holds (even though rates have gone up), Every $100M of debt reduction yields $4.6M before tax or let’s call it ~$3.5M after-tax (assuming US corp tax rates) or +1.5% to FCF. So $400M of debt paydown will boost FCF 6%. Not a ton, but its something. Secondly, at these valuation levels - even if it gets to my PT’s implied valuation - buybacks will be nicely accretive.
Lastly on this point, while I don’t want to build in the “paint by numbers” accretion to the equity from debt reduction, I’ll note that such upside is also compelling if it were to come through - As a fairly levered entity at a very cheap EBITDA valuation, $400M of debt reduction
Variant Perception
Faulty assumptions in the thesis and / or the market won’t care if I’m right
Boiled down, my thesis is that consensus is too low because margin expectations are too low, because TTMI’s AAPL issue from 2017 is no longer in play and lazy sell-side models haven’t properly factored in Anaren. Obviously, I have a basis for my view as outlined above; that said… 1) there could be offsetting factors on the margins (CPU shortage hitting PCs, tariffs, wtvr); 2) iPhone release dates notwithstanding, units could underwhelm (again); or 3) no one cares about the margins if they see weakness in auto/industrial or something on the top-line. However, the large delta in where I think estimates should be vs. where they are creates some cushion from my POV.
CHINA!!
TTMI does most of its manufacturing in China. To be fair, I’ve been involved in TTMI for a while and have done well until the recent meltdown, so from my POV, I don’t look at it as starting an investment today that carries China risk. That said, for anyone reading this, that’s exactly what I’m implicitly advocating. “China risk” is obviously something to note, both on tariffs and on any other trade-war collateral damage. Of course, TTMI tariff exposure would only be on shipments to the US proper, whereas most of their US customers do manufacturing abroad (e.g., PC manufacturers or AAPL doing assembly in the far east). Calling a spade a spade - I don’t view the China situation as one of permanence, but rather part of a larger political game; this says nothing of its wisdom, only that my general view is that the tariffs are not in place for tariffs-sake, but rather as part of larger negotiation strategy. As a result, I view this is a timing risk not a thesis risk
Exposure to cyclicals at a bad time
Similar to China risk above, I view this as more of a timing risk vs. a thesis risk. TTMI has 20% exposure to auto, sizeable exposure to industrial (hard to tell exactly, bc its grouped with a few other things, but the group its in comprises ~15% of rev), and high-teens exposure to networking/comms that’s been going through a tough 4G-to-5G spending gap. Additionally, the Anaren deal increased exposure to A&D, making a bet there, which >20% exposure. All that said, TTMI is well-diversified (no area larger than ~22% of rev) and these issues are more timing-related. In fact, even with lower SAAR and a slowdown in industrial production expected, the content story in auto/industrial continues to provide growth to its participants
Low-quality business with high customer concentration
TTMI is a low-margin business with lots of competitors and theoretically low barriers to entry, in addition to high exposure to AAPL (~15% of rev). This is more of a general view of the company and its industry, in terms of many wouldn’t want to get involved on that alone, or don’t believe there will never be val multiple upside. I’ll save my view on the difference between commodity vs. substitutable products, but there’s stability to the biz in my view. Net/net, granted its not anywhere near a high-moat biz, but its not under constant attack/pressure either.
Higher leverage than peers; deserves its multiple
Given TTMI’s roll-up / M&A strategy, they carry leverage, whereas many of their peers don’t at all, or much less. The easy argument would be more leverage = lower multiple, particularly in this kind of a business. In my view, the leverage doesn’t hamstring them. Further, the more stock put into the leverage issue, the more the debt paydown angle should be attractive.
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