Description

Introduction & Hindsight Analysis of Previous VIC Write-up

VTech has been written up before on VIC as a short (at HK107/share) in November 2014 by Siren81. The short thesis was based largely on the following points:

• Secular decline (forecast: -15%) of VTech’s “largest and most profitable” (at the time) business segment, Telecommunication Products (TEL).

• “Structurally flawed” Children’s Tablet business - part of the “platform” sub-segment which accounted for 32% of the overall Electronic Learnings Products (ELP) business - in the face of rising competition from software apps that can be deployed in generic tablets, which were rapidly dropping in price.

• The remaining contract manufacturing business (CMS) a “Low Margin Commodity Business” where the company will be unable to earn an adequate return on capital over the long-term.

The combination of these factors would lead to a decline in operating income, leading to a dividend cut of 15%.

What followed over the next four years (FY2015 to FY2018):

• TEL declined, but much slower than expected (5.1% organic decline). This was mainly because of solid growth (23% p.a.) in the non-residential segment.

• The ELP “platform” sub-segment declined faster than expected, but the ELP “standalone” business performed well, leading to lower-than-expected overall decline (1.5% organic).

• Gross margins were stable in the 32-33% range, with increasing contribution from the contract manufacturing business.

• Operating income declined from ~$225 million to ~$200 million the following year (FY2015).

• In 2016, the company did indeed cut its dividend, but this was primarily because it was acquiring Leapfrog Enterprises, its direct competitor in the ELP space.

• For consideration of $71 million, the acquisition added $174 million in revenue. After a year of integrating business (primarily taking its formerly outsourced manufacturing in-house), operating income increased back to an all-time high of $227 million in FY2018.

• The stock price hit an all-time high of HK124/share in June 2017.

This would have been an unprofitable short during the first four years as the company paid out $681 million in dividends and organically funding $86 million worth of acquisitions out of internal cash flow.

That said, holding a short position would have paid off over the following two years (through FY2020):

• In 2018, margins began to decline from the 33% area to 30%.

• Margin pressure continued into 2019 along with the imposition of new tariffs in the US.  The stock price descended to the HK70/share range.

• The stock price declined precipitously in 2020 with the onset of the pandemic and reached a low of HK42/share in July 2020.

• Despite healthy earnings for the fiscal year ending March 31, 2020, the company announced a reduction in its dividend payout to 70% “to conserve cash [and] … ensure the Group has ample resources to navigate the exceptional period of turbulence.”

If the short had been covered at the very bottom, the trade would have made a modest profit of around HK33/share (over five years from FY2015 to FY2020, the company paid out HK32/share in aggregate dividends).  It took longer than expected, but overall it was a successful short trade if you had held onto it through this past summer and covered at the lows.

That said, five plus years later, the facts have changed and with the stock trading close to decade lows, I believe this is now an attractive long.

Summary Financials and Trading Metrics

Note: The company’s stock trades in HK dollars, but reports financials in US dollars. Most of the financial figures in this report are reported in US dollars but share prices are reported in HK dollars (except in the table above).

Company/Industry Overview 

VTech is a best-in-class export-oriented manufacturer of branded telecommunications equipment and electronic learning products for children under the VTech and Leapfrog brands, and non-branded contract manufacturing services for specialty verticals including high-end audio, hearables, industrial/IoT and medical equipment.  The company has an established manufacturing base in the Pearl River Delta region in China (now increasingly referred to as the “Greater Bay” region) and has recently expanded to Malaysia (Penang region) in the wake of US-China trade tensions.

The company was founded in October 1976 by Allan Wong and another co-founder.  It originally focused on video game consoles, electronic learning products and computers before diversifying to telephones in the early 1990s.  By the late 1990s, VTech had divested non-core businesses to focus on telephones and electronic learning products.

VTech’s core manufacturing competencies fit well with relatively mature “non-platform” electronic product categories that differentiate through “non-sophisticated” R&D (mainly custom chip and PCB design) and are typically delivered in smaller lot sizes (tens of thousands per SKU vs. hundreds of thousands or millions as in the case of smartphones).

Relying on its core focus as the low-cost provider, VTech is largely agnostic to distribution strategy. Within the TEL segment, VTech developed its own brand and retail channels for the North American market, but in Europe relied largely as an ODM provider partnering with telecom providers like Deutsche Telekom.  It was able to successfully expand from the residential phone segment to the commercial market.  Within the ELP segment, VTech was able to deftly transition through the bankruptcy of its once-largest end customer, Toys ‘R Us.  Within the CMS segment, VTech by default works flexibly with its clients across a wide variety of product categories and distribution strategies.

In 2000, VTech made its first major acquisition by purchasing the consumer telephone business of Lucent, which gave it the rights to the AT&T brand for 10 years.  Initially, this led to operating losses but the company turned around the business and it has been profitable ever since. VTech’s manufacturing excellence was a driving force in the consolidation of the industry and the company has been able to survive or even thrive at times in mature industries by out-executing the competition and methodically increasing market share over time.

Allan Wong, now 70 years old, is the current Executive Chairman of the company and owns 35% of the company.  He is primarily compensated through his share of the company’s dividends.  He also sold 10 million shares at HK82/share a decade ago.  Since 2002, the company has paid out approximately $2.4 billion in dividends.

Cordless Telephones. Let’s start with the business VTech is most known for and the least attractive one: The core TEL business line has been declining for what seems like “forever”.  I recall when I first came across the company a dozen years ago during the depths of the Global Financial Crisis when the stock price was trading at HK18-19/share range (~4x price/earnings ratio).  This looked like a “too good to be true” situation and I moved on after rationalizing that it must be due to the imminent collapse of this business line. After all, who was still buying cordless phones?

To my chagrin, the TEL segment did not fall off a cliff and instead, actually grew through deft management.  Since FY2009, the company has since paid out HK66/share (over 3x the share price at that time) in cumulative dividends to shareholders.

To extend the life of this vertical, VTech has methodically consolidated the competition, penetrated the commercial sector and expanded the product line (e.g. baby monitors).  Today, the “Commercial and Other” sub-segment accounts for more than half of total segment revenue.

Even so, the business has continued to decline since peaking at $742 million in revenue in FY2010.  At first, this was a fairly graceful decline (especially compared to expectation) but the rate of decline seems to have picked up in the last three years.  Business is now around half of where it was at peak ($401 million in FY2020) and both sub-segments are in decline.  TEL is also a lower-margin business than ELP.

Learning Toys for Babies & Toddlers. The ELP business has been a steady-state business for a while. Focused on early childhood (newborns through age 6), this product line is comprised mainly of electronic toys for babies and children under the age of 6 - at which point many start transitioning to apps on iOS and Android devices.  ELP generates the highest gross margins in the business, which I estimate to be in the 35% area.

In the mid-2000s, VTech extended the product line with “platform” products like e-readers and video consoles, but as the rise of iOS and Android tablets closed off a potential growth area: VTech has since re-trenched to focus on on traditional “standalone” electronic toys, competing with the likes of Hasbro and Fisher-Price.  “Standalone” toys account for 80% of revenue today, up from 68% eight years ago.

The most recent significant event was the acquisition of its main competitor, Leapfrog, in April 2016 for approximately $71 million (0.4x revenue).  The acquisition price was relatively low because Leapfrog could not be run profitably competing against VTech (it outsourced its manufacturing).  The company has since incorporated the Leapfrog brand alongside VTech and is the largest within the early childhood learning products segment with 23% segment share.

Contract Manufacturing for Specialty Verticals.  For these first two segments, the investment thesis has not changed materially over the last decade plus and is frankly, not that exciting.  There isn’t much debate about the prospects of these businesses.  Revenue and cash flows can be valued in a fairly straightforward manner.

What caught my attention recently was the steady growth in the contract manufacturing services division.  A decade ago, this was a $281 million business comprising less than one-fifth (18%) of VTech’s overall revenue.  Today, it is a $842 million business comprising nearly two-fifths (39%) of group revenue.  Its growth has more than made up for revenue decline in the TEL segment.  In doing so, VTech has demonstrated the ability to expand manufacturing capabilities across other product verticals. Today, its CMS segment produces professional audio equipment, hearing aids, industrial/IoT devices and medical/hospital equipment on an OEM/ODM basis.

While VTech does not break out gross margins by segment, it is notable that the overall gross margin of the company has not contracted significantly even as contract manufacturing has increased as a percentage of overall revenues.  This suggests gross margins that are in the mid-to-high 20s, which is significantly higher than typical commodity PC/smartphone contract manufacturers.  VTech is able to generate higher contract manufacturing gross margins because it is focused on smaller-lot, higher-value product segments (“professional, industrial and commercial”) including professional audio and medical equipment.  VTech has 1,600 R&D staff that add value through product and component design.

VTech is often able to grow by transferring production of an existing product line from a customer that is looking to get out of the manufacturing business.  The most recent example was the 2018 purchase of Pioneer Corporation’s DJ equipment (e.g. mixers, scratch pads) business along with its in-house manufacturing assets in Malaysia.

Investment Thesis

VTech is an opportunity to buy into a well-run, below-the-radar company that has high income and moderate growth potential via both organic expansion and acquisition.  VTech is a low-cost manufacturer with some pricing power, having developed (with in-house R&D) or licensed successful consumer brands in the past.  This differentiates it from the typical Hong Kong export-oriented manufacturer.

Like many first-generation Hong Kong export businesses, the shareholder base is concentrated so as an investor you are signing up to go along for the ride with the owner-operator, Allan Wong.  Listed on the Hong Kong Stock Exchange since 1986, the company has clean financials, excellent disclosure and a consistent shareholder return on capital policy (almost entirely through dividends).  The company has consistently paid out nearly all of its net profit with the only exception being FY2017 when it was preparing to acquire Leapfrog.

Based on long-term earnings, you are buying into a stable earnings stream at about 8-9x after-tax earnings, good for a ~11-12% earnings yield.  As the business requires little in the way of capital to grow, the company has been able to return nearly 100% of earnings (or fund acquisitions) out of these earnings.

Given the small-cap nature of the stock (<US$2 billion market cap, <$5 million/day in trading volume), this investment is suitable for smaller funds.

The knock against VTech for most of the past dozen years was that its cordless telephone business was dying. But through intelligent capital and resource allocation, it has been able to weather this decline by:

1. Methodically growing its contract manufacturing business

2. Opportunistically acquiring and consolidating competitors

(1) From >50% of consolidated revenue fifteen years ago, the TEL business line is now less than 20% of overall revenue.  Meanwhile, the CMS business segment has grown organically for 18 years in a row at a 12.5% compounded annual rate.  Today, CMS comprises 39% of overall revenue.

VTech’s contract manufacturing business is not a low-margin, commodity business.  Over the years, VTech has entered product segments where it is able to leverage its core manufacturing competencies.  For example, VTech has a long history of manufacturing professional audio equipment, e.g. digital scratch pads and mixers used by DJs.  These segments tend to be lower-volume but higher-margin with stable competitive dynamics.

VTech is not going head-to-head against contract manufacturing behemoths like Foxconn or Pegatron in high-volume, low-margin segments like smartphone and PC manufacturing.  These segments typically feature gross margin percentages in the 4-8% range.

(2) VTech has a track record of making smart acquisitions at discounted multiples and successfully integrating these acquisitions into the business.

Most notably, it acquired Leapfrog Enterprises in 2016 after Leapfrog had been run unprofitably for years, ostensibly due to competition from VTech in the early childhood educational toys market.  The acquisition was funded out of internally generated cashflow (VTech reduced its dividend that year to fund this acquisition) at a 0.4x revenue multiple (VTech’s stock price has historically traded between a 0.8x to 1.6x multiple of revenue).

The Leapfrog acquisition helped VTech consolidate its leading market position in the segment, raising market share to 23%.  VTech also demonstrated that it was able to successfully absorb and integrate Leapfrog’s operations within 12 months of closing the acquisition.  In its public filings, VTech disclosed that Leapfrog contributed $16.5 million in operating losses in FY2017 (the first year under VTech).  By the following year, VTech’s operating margins had bounced back.  Not only that, the Leapfrog-branded product line has performed better than the VTech product line over the past financial year.

VTech’s most recent acquisitions have been in the contract manufacturing segment.  In August 2018, VTech acquired the manufacturing operations for Pioneer-branded high-end audio products in Malaysia.  The company paid approximately $20 million for assets that delivered pro forma revenue of $65 million and $2.4 million in net income.  The acquisition also diversified VTech’s manufacturing operations outside of China for the first time.  

Assuming VTech was able to fully integrate this operation into its prevailing cost structure, the operation would deliver around $6.5 million in operating income, yielding attractive valuation multiples of 0.3x revenue and 3x operating income, respectively.

VTech has indicated interest in making more acquisitions.  During the recent pandemic, Executive Chairman Allan Wong declared that the company “is still observing opportunities for cheap acquisitions after the pandemic abates, as it has adequate cash.”  VTech has always maintained a conservative balance sheet and has historically funded all of its acquisitions out of internal cashflow generation.

VTech now has a modest growth tailwind (with a caveat). After nearly over a decade of dealing with its largest product segment operating in a disappearing product category, now that TEL is less than one-fifth of revenue, VTech has gotten over the hump and may even benefit from a modest growth tailwind going forward.

Assuming long-term growth rates from FY2021 to FY2027 of ...

• TEL: 10.9% annual decline vs. average of 6.3% annual decline over the last decade

• ELP: 1.4% annual growth vs. average of 4.1% annual growth for the last decade

• CMS: 7.3% annual growth vs. average of 11.1% annual growth for the last decade

… total consolidated revenue should grow around 2.5% per year over the same period.  By the end of this period, TEL will only be 7% of total revenue while CMS accounts for 53%.

The major caveat here is that the current fiscal year (FY2021) is expected to be a down year, as VTech will be hit by the double-whammy of the pandemic affecting its main export markets as well as a relatively sharp appreciation in the RMB (current level: 6.6).  I estimate potential impact of up to $70 million in cost increase.

Historically, VTech has done a commendable job of dealing with a rising RMB.  From FY2007 to FY2014, the RMB appreciated from around 7.5 to 6.1.  During this time period, VTech was able to maintain operating margins by continuously improving employee productivity; over the last seven years, VTech has reduced its number of employees by ~30% even as revenue has increased by 17%:

In line with consensus estimates, I am forecasting operating income declining from $214 million to $153 million this year (FY2021).  This is driven by an overall 10% decline in revenue and a compression in gross margins from 30.6% to 29.3% due to the appreciation of the RMB and continuing impact of tariffs.

As the global economy digs out of the pandemic-induced recession, I have forecast a return to growth in FY2022 and operating income improving back to the $200+ million level.  This is similar to what happened a dozen years ago during the Global Financial Crisis, which in hindsight turned out to be an opportune (albeit fleeting) time to purchase VTech shares.

At its core, VTech is a manufacturer. As the business incrementally transitions towards CMS, it becomes even more clear that VTech is, at its core, a manufacturer.  In-house brand development experience is a plus but we really need to look at VTech as a premium contract manufacturer.

When most people think of contract manufacturers, they think of electronic contract manufacturers such as Flex.  Here are some past VIC write-ups on Flex:

• Flex (2015)

• Flex (2018)

• Flex (2020)

However, VTech’s CMS segment is quite different from traditional EMS companies.  One way we can see this is in the difference in margin profile.  Typical EMS companies that service the IT and telecom industries add value by organizing assembly lines and labor.  They add little in the way of product design or development.  As such, these companies typically feature gross margins in the 4-8% range.

I estimate that VTech generates gross margins in its CMS segment in the 20-30% range.  There is typically a design component involved, which is why the company has 1,600 R&D personnel.  Even though the added value is not particularly sophisticated (e.g. the embedded hardware that powers an electronic toy or digital DJ equipment), it does allow VTech to capture a higher share of the ultimate product value.  In addition, by focusing on more mature, specialty niches, there isn’t as much competition and pricing pressure.

Potential Upside: VTech the Consolidator. As alluded to earlier, VTech has a solid track record of creating shareholder value by acquiring and integrating acquisitions.  These acquisitions have often been inexpensive, low-risk ways to purchase established brands like Leapfrog and AT&T (via the acquisition of Lucent’s telephone assets in 2000).

Historically, the company has paid around 0.4 to 0.5x revenue (compared to trading multiples in the 0.8 to 1.6x range) and been able to successfully integrate these acquisitions into its prevailing cost structure without significant loss of revenue.

Normally, I see companies that are serial acquirers as red flags.  However, in this case, the downside risks are low because investors are fully aligned with the key decision-maker (Allan Wong) based on his long-standing 35% ownership of the company.

VTech’s contract manufacturing segment is a source for acquisition targets. The company often wins new business from retail brands that are struggling with in-house manufacturing or having issues with their outsourced manufacturing partner.  VTech has a demonstrated track record of being able to successfully integrate manufacturing operations for a wide variety of electronics products.  In its most recent major acquisition, of Pioneer Corporation’s DJ and professional audio equipment product line (~$65 million in annual revenue), VTech acquired what had been an in-house manufacturing facility.

Like a strategic acquirer, VTech is able to leverage its manufacturing know-how and scale to reduce product cost and increase operating margins. My background was in private equity, so I know the advantage of being able to partner with a strategic acquirer on acquisitions. Investing in VTech is an opportunity for public investors to take advantage of this dynamic.

Recent comments from the Executive Chairman suggest that the company is actively seeking acquisitions on an opportunistic basis.  These acquisitions are likely to be value-creating shareholder events, especially if they follow the prevailing blueprint of established brands that are struggling from an operational/manufacturing perspective.  Fall-out from the pandemic has negatively impacted many established brands, and this could be a target-rich environment for a well-capitalized, low-cost manufacturer like VTech.

Key Downsides and Risks

• Continued fall-out from the US-China trade war.

• Some of slowdown and margin compression over the past two years can be attributed to the imposition of tariffs commencing Q3 2019.

• A 15% tariff was imposed on VTech’s residential cordless phone business on September 2, 2019 (subsequently reduced to 7.5% on February 14, 2020). 

• Some of VTech’s CMS customers have also been affected by tariffs, ranging from 7.5% to 25%.

• All of the ELP products are exempt from US tariffs.

• The company also took proactive steps to diversify its manufacturing production base two years ago with the purchase of manufacturing facilities in Penang, Malaysia.

• The company has continued to expand these facilities with the express purpose of serving the US market to avoid tariffs.  These facilities will be able to serve ~25% of the company’s production capacity by March 2021.

• Sharp appreciation in the Renminbi and general labor costs in China.

• So far, the RMB has appreciated about 5% in 2020.  Labor costs account for approximately one-fifth of product costs.

• Other important components include PCB boards, custom ASICs, and plastic/metal casings.

• Poor execution in the contract manufacturing business.

• The bear case for VTech has always rested on competitive dynamics putting pricing pressure on the existing businesses.  Without the stabilizing effect of a consumer brand, the contract manufacturing business is clearly the most at risk for margin pressure here.

• As such, the contract manufacturing business is more heavily reliant on strong execution by the team - identifying new product verticals, serving existing customers, etc.

Potential Catalysts

• The company will report interim results (six months ending September 30, 2020) in the second or third week of November.  Management has already guided that revenue will be down in all three segments.  Specific guidance on profits has not been provided.

• Announcement of a new acquisition.

Catalyst

• The company will report interim results (six months ending September 30, 2020) in the second or third week of November.  Management has already guided that revenue will be down in all three segments.  Specific guidance on profits has not been provided.

• Announcement of a new acquisition.