Description

Investment Thesis – VTech Holdings common stock is a short because:

â–  VTech’s largest and most profitable business lines face irreversible secular decline. This decline is not yet priced into the stock as market share gains have been able to mask a dying market for VTech’s products

â–  VTech is a ‘yield’ stock held by investors seeking high dividend payments. However, given a current payout ratio of close to 100%, declining cash flow will readily prompt a dividend cut

Business Overview

VTech is best thought of as four discrete businesses:

Phones (35% of sales) – VTech is the world’s largest supplier of cordless residential phones with a global market share in excess of 35%. Approximately 60% of sales are in the US and 27% are in Europe.

InnoTab (15% of sales) – InnoTab is a children’s tablet computer providing age-appropriate games and media. InnoTab is the leading children’s tablet in Europe and the #2 device in North America.

Other Toys (25% of sales) – Produces 100’s of different competitively priced toys for infants and preschool aged children. No single product represents a material portion of this segment’s sales.

Contract Manufacturing (25% of sales) – VTech is the 27^th largest contract manufacturer globally with three factories in mainland China. Customers are generally mid-size producers of professional audio equipment, appliances and electrical components. Approximately 60% of sales are in the US and 27% are in Europe.

Market Share Gains Mask Secular Decline of the Phone Businesses

It should not be surprising that the market for residential phones is quickly dying as home phone service is replaced by mobile and IP-based service. Indeed, this is exactly what appears to be happening in the company’s European business as European phone sales are steadily falling despite a generally improving economy.

However, in the 6 months ending September 2014 US phone sales actually increased 6.8%. According to the company, this unexpected sales increase was caused as VTech “continued to gain market share in North America on the back of a declining market”. I believe this is referring to Uniden’s exit from the US phone market which resulted in VTech’s market share climbing over 10%. As such, sales increased even though the market continues to decline. However, Uniden’s exit is now nearly complete and thus sales are likely to fall in-line with the market going forward. Furthermore, VTech’s only remaining competition is from Panasonic which should benefit from a cheaper Yen and allow Panasonic’s to be priced more competitively with VTech.

The Children’s Tablet Business is Structurally Flawed and Will Slowly Decline

InnoTab has been a highly successful product for VTech as the company was an early entrant to a fast growing market. However, there are 3 reasons this business is now dying:

The Category Itself Is Obsolete – Children’s tablets became popular a few years ago when adult tablets cost $500 and the software options for children were limited. Today, quality hardware is available from Google/Samgung/Amazon for <$150 and prices continue to fall. These devices provide access to thousands of children’s applications, many free or low cost. As such, the entire notion of a dedicated “children’s tablet” is questionable and will only become more so as hardware prices fall and software options increase.

Competition is Exploding – The proliferation of Andriod software has made entry into this category much easier. In the past year 7 companies have launched android-based children’s tablets, some for as little as $50. VTech has stated that this competition resulted in increased discounts in the recent holiday season.

Proprietary Platform is Unsustainable – InnoTab is based on a wholly proprietary hardware / software platform. As such, the device does not integrate with other systems and VTech must employ over 100 in-house engineers to write all systems and applications. Even with all these developers, software selection will never compare to android models and the record of similar proprietary systems is exceedingly poor.

The Remaining Businesses are Low Margin Commodity Businesses

Aside from the phone and InnoTab businesses, the toy and contract manufacturing segments are commodity businesses where VTech has low market share, no brand or IP and no competitive advantage. As such, competition is largely based on price and the company is unlikely to earn excess returns over-time. Furthermore, the contract manufacturing business is currently running at over 90% capacity, so any expansion in this segment will require significant capital expenditures.

VTech is a ‘Yield Stock’ with a Nearly 100% Payout Ratio

As is often the case with high yielding stocks, VTech’s stock price appears to be a function of dividend payments rather than overall business fundamentals. Since VTech’s stock price is supported by a current dividend yield in excess of 6%, the resulting trading multiples are well in excess of what is justified by the company’s prospects.

Figure 1: VTech Trading Multiples

As shown below, in order to support such large dividends VTech must pay nearly all cash flow to shareholders.

Figure 2: VTech Use of Cash

Declining Cash Flow Will Cause a Dividend Cut

Since VTech requires all current cash flow to support its dividend, it follows that a decline in cash flow will result in a decline in the dividend and thus a decline in the stock price. Exactly how fast cash flow will decline is unclear, but it is possible to make some reasonable assumptions. Adjusting for the one-time market share gains, it appears sales in the Phone segment are falling about 15% per year. If we assume at 10% decline in InnoTab and apply the segment gross margins the company guides to this decline will result in a 15% annual drop in the company’s dividend.

Figure 3: Cash Flow Declines Will Cause Dividend Cut

Risks / Considerations

It is possible that VTech can take actions to offset the decline in the phone and InnoTab business such as continuing to take market share in phones or designing successful product updates for InnoTab. It is also possible that growth in the other segments offsets any drop in the profitability of phones or InnoTab. However, in either of these scenarios total profits would be unlikely to grow and given the high multiple VTech currently sells for, downside seems limited to paying out the dividend of about 6% per year. As such, our risks for this position appear acceptable.

Catalyst

Dividend cut