Description

SUMMARY:

Varta is a classic over-earner – benefiting from an unsustainable first-mover advantage in the market for coin-shaped Li-ion batteries used in TWS headphones such as the Apple Airpods. As this market has taken off, Varta is going from being the sole supplier to all its customers in 2019 to now being multi-sourced with many Chinese/Korean competitors coming in at meaningfully lower prices in 2020... We have confirmed that all its major customers ex-Apple have now added additional suppliers to Varta. Two suppliers are currently working closely with Apple to be potentially designed into the new model of Airpods slated to be introduced in Q1 ’21. As Varta goes from being the sole source in an undersupplied market to one of 2-4 vendors at each of its customers, we think current expectations for revenue and margins embedded in street numbers will prove to be too high. While market unit growth could continue being healthy, we think expectations of stable pricing and margins are egregious. Trading at ~26/20x the street’s current ‘21/’22 unrealistic earnings expectations we think there is 40-50% downside in the shares.

COMPANY DESCRIPTION

Varta is a battery manufacturer based in Germany. The company established itself as a manufacturer of coin-shaped microbatteries for hearing-aids with ~50% global share (~18% of sales). When Apple’s Airpods were introduced in late 2016, their popularity and those of other knock-off designs spawned a new high-growth category of True Wireless Stereo (TWS) headsets. Varta was able to leverage its know-how to becoming the first supplier of rechargeable coin-shaped Li-ion batteries to most of the premium brands in the market. The category has grown rapidly, from ~100mm premium headsets in 2019 to ~200mm expected in 2020. Based on guidance for 2020 (only 1 quarter remaining), TWS batteries account for ~1/3 of sales and ~2/3 of EBITDA with the other 2/3 of sales  closer to GDP-type growth (hearing aids grow MSD and consumer batteries LSD). ~90% of forward growth expectations for the company come from TWS batteries. A snapshot of the business is below:

DETAILS:

1)   TWS headsets took off with Airpods and Varta was there early – but that is rapidly changing

·      The introduction of AAPL’s Airpods in 2017 gave birth to a new category of cordless TWS headsets. These headsets require rechargeable Li-ion batteries in each earpiece in a compact coin-shaped form factor. Given Varta’s experience in producing disposable batteries for hearing aids in a similar form factor, the company was able to leverage this to being a first mover in the TWS market.

·       Stats on the precise number of premium TWS units are hard to come by, but we approximate AAPL sold ~60mm Airpod units in 2019 and is on track to sell ~90mm units in 2020. We believe AAPL has generally represented ~50-60% of the premium market, and put the TWS headset market at ~100mm units in 2019 growing to ~200mm units in 2020. Of these headsets, the percentage using coin-cells – the type made by Varta (vs cylindrical cells) – has grown from ~33% of the market in 2018 to ~50% in 2019 and ~70% in 2020.  Based on Varta estimates of units sold and ASP (~€2.50) we estimate Varta’s market share in premium coin-cell batteries to be ~80% in 2019 and ~70% in 2020. We think this high level of market share and profit margin is unsustainable given identical product specs and capacity ramps from Asian competitors.

·      Varta had capacity to produce ~70mm units annually at the end of 2019 and has announced plans to increase that to ~200mm by Q1’21 and eventually 300mm by year end 2021. The capex required for that expansion is ~€450mm. Given we know that the ASP of Varta’s Li-ion cells are ~€2.50 currently and cash gross margins are ~80%, that implies a cash-on-cash payback on capex of ~1 yr. We think these unit economics are unsustainable. Our conversation with Chinese/Korean battery suppliers indicates that their capex/mm annual units is significantly less than the ~€2/mm at Varta. They are typically selling comparable SKU’s to Varta at 20-30% discount and making a ~60% cash gross margin on it today because of lower yields. Even assuming an equivalent capital intensity at Asian competitors, it implies a cash payback on capex of <2 years. We think at these economics Asian competitors are rapidly expanding capacity and from industry conversations are aware of at least 6 of scale that have secured contracts with headset makers.

o   Samsung SDI – curr capacity ~25mm/yr, expanding to 75mm/yr. Samsung is a customer. Focus on AAPL for next yr.

o   Eve Energy - 100mm/yr ramping to 200mm/yr by YE21. In Samsung and all Chinese brands are customers. AAPL 21?

o   Great Power - ~90mm/yr capacity now and ramping to ~120mm in 21. JBL, Harman, Xiaomi, Huawei customers.

o   MiC Power – ~60mm/yr capacity. Jabra is a customer.

o   VDL - ~100mm/yr currently. Big cust list – Xiaomi, JLAB, Bang & Olufsen, Sony, Plantronics.

o   Zenipower – ~50mm/yr capacity. Philips, Sony customers.

·       Ultimately, we think Asian competitors will be able to close the yield gap to Varta to <15% and improve their cost structure over the next 12 months. We think they will be happy with a fully loaded gross margin of ~30% or cash gross margin in the upper 50’s with a price point 20+% lower than where we are today. Price competition against these economics we think risks lowering Varta’s EBITDA mgns ~13-15% lower than where it is today.

·      Based on third party data and industry conversations, we think Samsung, Sony, Xiaomi, Huawei, Jabra, Bose, B&O are some of the other OEMs in the premium segment that do >5mm units annually. We have been able to speak to ALL these brands or battery suppliers into these brands directly. We believe all of them are already sourcing from at least one alternative vendor to Varta and intend to only increase their non-Varta sourcing at better prices. Our conversations with Eve Energy and Samsung SDI indicate that both these vendors are increasingly confident of breaking into Apple’s Airpod supply chain with a release of new model(s) in early 2021. We are very confident Varta will not be able to maintain its current market-share, margins or price points.

·     Given our extensive industry conversations with both competitive battery makers as well as headset customers we feel increasingly confident that Varta’s days of enjoying sole-source or premium supplier status at all its ex-AAPL customers is about to end. Current street expectations of rather flattish price declines in TWS batteries seems extremely bullish given customers already sourcing equivalent product SKU’s from Asian competitors at 20-30% lower prices and indications of further price declines of at least 15-20% into 2021. We think the price stability of the last 2 years has been a function of the market being undersupplied and see that rapidly changing in ’21. 

·       We believe '22 EPS will be ~€3 vs current street expectations of ~€5.50.

2)   Rest of Varta’s business does not grow much – undeserving of a high multiple

·       Varta’s rich valuation today is predicated on high growth in TWS batteries. When this comes to an end, we believe the overall business deserves a lower multiple because of low growth in its consumer and hearing aids segments. 

·     Consumer batteries grow low-single-digits. While it is a stable business, the business was recently acquired from Energizer for ~4.5x EBITDA/10x NI, reflecting relatively unexciting growth prospects.

·     Hearing aid units have grown mid-single digits but the rapid shift to rechargeable batteries shrinks the market for Varta as the price of a single rechargeable battery is less than those of disposables over the life of the hearing aid (typically 4 years). We expect this business to enter sustained decline in the next few years. Rechargeable hearing aids have recently crossed 50% market share and are continuing to rapidly gain share. We expect the installed base consumption to move meaningfully to rechargeables over the next several years at which point we believe the market is unlikely to place a big multiple on this business. 

Catalyst

        Increased multi-sourcing at Varta’s existing customers – especially Apple (only one still single sourced). We think it is very likely with the new Airpod models coming out in early 2021.

·      Increased price competition as Chinese/Korean competitors ramp up supply.

·      Possible declines in hearing aid batteries as rechargeable’s significantly cut consumption of disposable batteries.