Description

BUSINESS DESCRIPTION + HISTORY

Volex is a contract manufacturer operating in two divisions - power cords and cable assembly. In its recent history from around 2000 through to 2013, the business was mismanaged with several successive management teams failing to generate sustainable, profitable growth. Specifically, I believe that these teams sought to grow revenues at any cost and while they succeeded in doing so, evidently this was achieved through price compression and margin erosion. Combined with the low and sometimes negative unit margins, the capital spend undertaken to win these clients was significantly value destructive.

In 2014, encumbered with debt, the business sought a bailout from shareholders, in which the current Executive Chairman took a 24% position. Alongside various other management changes, this new team has affected an impressive turnaround and re-positioned the business with much improved operating margins - from 1% to around 6% - generating free cash flow and with a net cash balance sheet. It has been stabilised and is now returning to profitable growth with a great runway for the future.

In May 2018, with much of the turnaround completed, Volex undertook a $50m placing in order to fund acquisitions, working capital investment and investment in automation.

The business today manufactures cables, printed circuit boards and sub-systems that go into other products. They operate through 13 factories around the world with over 6,000 employees supplying to many blue-chip household names. They are focusing on growth areas: medical complex sub assemblies; high speed data centre interconnects; and electric vehicle plugs, connectors, and cables.

INVESTMENT THESIS

> Strategy

I believe that the (new) strategy has great merit. Organically, management are focusing on higher margin activities in both divisions, as a result I think that power cords can achieve around 8-10% operating margins and the cable assembly division can achieve 10-12%. I think that group margins (after central costs) can reach 8-10% after central costs (almost 2x higher than current), on a growing revenue stream.

Inorganically, the management team have outlined a desire to consolidate a highly fragmented market. To date, they have done so at very attractive multiples ranging from 2-7x EV/ operating profit. Acquired businesses benefit synergistically from Volex’s purchasing power and geographic reach as well as the ability to cross-sell to existing customers. Customers benefit from dealing with fewer suppliers with more uniform engineering and quality requirements.

Customer concentration has historically been a real drag on the business with the top 10 customers accounting for around 75% of sales. The top 10 now are less than 30% and should continue to drop.

> Organic revenue growth

Underlying the acquisitions, and the decline of Apple as a major customer (a strategic decision by management) revenues have demonstrated growth of 8-10% in the divisions. I believe that there are several initiatives which may continue to drive this, particularly as management focus on structural growth angles such as electric vehicles and data centres. Part of the problem with Volex’s perception has been the running down of certain overweight/ unprofitable customers which has always required explanation and made the rest of the business look lower growth. I think that Apple is now close to bottomed out and therefore the power cords division should now demonstrate clean growth in line with the above.

> Acquisition/ consolidation

Since May 2018, the company has acquired five businesses with combined pro-forma revenues of around $120m and operating profit of $14m, for a total consideration of around $82m. This indicates that they have paid c6x. The acquisitions are accretive to operating margins with an average of 11.5% at the operating level. This is helping to pull up group operating margins prior to any synergistic benefits realised. There has been some attempts made to vertically integrate which would help the story and generate sustainable margin improvements.

> Free cash flow generation

Contrary to its capital-intensive past, I expect Volex to require only a minimal amount of maintenance capex going forwards. Partly due to fewer sites following a long restructuring (some of which is ongoing) and since the management team are more prudent with their cash. Maintenance capex ought to run between $4-5m for the current business, slightly higher than depreciation. I believe that certain expensive capital projects, such as an ERP system, have been avoided though acquisitions which have brought across newer systems and processes which have been rolled across the group.

After a significant working capital investment in the 2019 financial year, in part to fund growth in electric vehicle contracts, I do not see working capital as a material drag/ risk to cash flow. The business is debt free, and management intend to run it that way, with a facility to provide some buffer for working capital. As a result, I think that operating profit cash conversion ought to be 90%+, supported by their newly introduced incentive scheme.

> Competitive advantages

Volex have a flexible manufacturing footprint which allows them to locate in regions with the most attractive labour rates, subject to customer requirements. Recently, with the US/ China trade tariffs, Volex have been able to relocate manufacturing from their Chinese sites to those in Vietnam and Mexico, bypassing the tariffs and improving customer stickiness. In order to shift locations, Volex have succeeded in having customers pay for new facilities and tooling. This effectively guarantees the business for some time as the customer requires to earn back the cost through savings. Volex’s competitors are typically solely China based, therefore they cannot offer this flexibility and I believe that Volex are already taking business from these competitors.

> Insider ownership

Management have a significant interest in the shares – around 25% in total, of which the chairman owns 24.2%. Since May 2018, including in the placing itself, management have spent around £9m buying shares in the market as the company has derated through a series of upgrades.

VALUATION

At this juncture I think Volex is a value, growth and momentum play with several very near-term catalysts around the results in November 2019, and then into the full year end April 2020.

Market cap £150m

Net cash at year end $20.6m

Post period adjustment: Servatron acquisition = $19.6m

Adjusted EV: c£150m

Forecasts

2018/ 2019/ 2020e/ 2021e

Revenue: 322.4/ 372.1/ 416.9/ 450.5

Adj operating profit: 11.5/ 21.6/ 30.5/ 35.3

Exceptionals: -2.7/ -8.6/ -2.4/ -2.4

Cash from operations: 5.0/ -6.7 (includes 24.7m of w/c investment)/ 25.8/ 30.0

Maintenance capex: -2.4/ -2.8/ -4.3/ -4.4

Adj. free cash flow: 2.6/ 10.5/ 21.5/ 25.6

The company is cheap – on a little over 5x EV/ operating profit for this current year, yet it is not in distress (far from it) or decline or showing operating issues. It is growing revenues organically and inorganically and has plenty of margin growth potential. It trades on almost a 50% discount to its closest listed peer despite generating better operating margins and, in our view, stronger competitive advantages, pricing power and a long growth runway.

The share price has not kept pace with the earnings upgrades since May 2018, up only 25% vs 2020e and 2021e operating profits increasing by 60% and 80%, respectively. This suggests a lot of latent value in the share price.

I am ordinarily wary of this gap and the market’s distrust in the numbers, however, I have great confidence that these numbers will be delivered since:

a) management have increased their shareholding by through the same period significantly through market purchases;

b) they have put an incentive scheme in place which will vest based on $25-28m of operating profit;

c) they have a history of underpromising and overdelivering with 3 upgrades in 14 months;

d) in a recent interview the FD alluded to $30m of operating profit for this year, which confirms the current forecast of $30.5m. If management’s track record continues, they should beat this number.

Crucially, I expect accounting profits to convert strongly to free cash flows. The business is less capital intensive than historically with a stronger focus on capital discipline. In fact, 15-20% return on capital deployed has already been demonstrated and I expect that it can achieve 18-20% over the long term. Management have outlined in their incentives 80-90% cash conversion, something which is supported by the forecasts. Again, mosaic points me to a business which will generate $20m+ of FCF - H219 reported $10m of FCF and I expect H120 to report something similar. Backed up by the same management interview where the FD alludes to “$20m of cash generated in the last 12 months” – I believe recorded after their half year end this year.

The short-term earnings are surely in the bag - that is around $30m of operating profit. I think that $35m is achievable on current run-rates from the acquisitions and very modest underlying growth. This is supported by consensus numbers.

Beyond this, there is a strong runway for growth aided in part by their burgeoning electric vehicle relationships and in data centres and health care. Inorganically, the opportunities to purchase sub-scale operators around 6x earnings is almost unlimited such is the fragmentation of the market and provides another growth leg if their multiple can grow above this.

I think that management’s ambition is to build a $600m revenue, 10% operating margin business. In line with a wide industrials peer group, I think that these metrics coupled with strong cash generation and supported by a growing dividend (maiden to be paid in Nov) could generate a 12-14x EV/ operating profit consideration in the UK market. This could come through organic and inorganic growth - crudely assuming $120m of fcf generated over the next 5 years, they could buy $20m of operating profit at 6x with no further dilution which would be highly accretive to the current share price.

Other relevant value metrics include the impending yield of c3% and around 1.2x p/book.

And a comparison of where Volex sits against other listed peers is also worth consideration:

CONCLUSION

Volex has an exceptional valuation and unrealised potential. There are tangible catalysts to drive a rerating and for growth across all time periods. There are attractive structural dynamics and a well invested, aligned management team. It has baggage in the form of a chequered past, but I think that it has outgrown this. Over a medium term horizon the business ought to double its multiple and increase earnings from $20m to $35m+ of operating profit. Over a longer period, earnings could double again. Patient investors will be rewarded with a growing yield from November.

CATALYSTS

I think that there are many catalysts for the share price currently.

Short term:

> Results on 14th November 2019 proving the first leg up of the growth. I believe that a trailing 12-month view (H219+H120) will show a $20m FCF business, with lower exceptionals, and stabilised margin improvements.

> Management have been pushing their IR hard as I believe they know that now is the right time to spread the story.

> Dividend will be reinstated at the results in November.

> Cleaner numbers/ lower exeptionals/ improved cash conversion and easier to see the underlying growth

Medium term:

> Continued cost focus/ self-help in the business drives margins and leverages increasing organic revenues.

> Perhaps aided by inexpensive acqusitions and/ or vertical integration which would make Volex more price competitive.

Long term:

> At the time of the placing in May 2018, management outlined a plan to dispose of their lower margin power cords business. This would generate significant cash for deploying a higher margin roll up strategy in cable assembly. I am unsure if this remains an intended strategy since power cords has been generating strong cash flow and there may be opportunities to become the lowest cost supplier in certain verticals through some strategic initiatives.

> Ultimately, the c30% shareholding management team will probably seek some sort of exit to a strategic/ trade buyer. There has been some activity in the sector to support this

Appendix:

Some visuals on what Volex does and the industries.

Catalyst

I think that there are many catalysts for the share price currently.

Short term:

> Results on 14th November 2019 proving the first leg up of the growth. I believe that a trailing 12-month view (H219+H120) will show a $20m FCF business, with lower exceptionals, and stabilised margin improvements.

> Management have been pushing their IR hard as I believe they know that now is the right time to spread the story.

> Dividend will be reinstated at the results in November.

> Cleaner numbers/ lower exeptionals/ improved cash conversion and easier to see the underlying growth

Medium term:

> Continued cost focus/ self-help in the business drives margins and leverages increasing organic revenues.

> Perhaps aided by inexpensive acqusitions and/ or vertical integration which would make Volex more price competitive.

Long term:

> At the time of the placing in May 2018, management outlined a plan to dispose of their lower margin power cords business. This would generate significant cash for deploying a higher margin roll up strategy in cable assembly. I am unsure if this remains an intended strategy since power cords has been generating strong cash flow and there may be opportunities to become the lowest cost supplier in certain verticals through some strategic initiatives.

> Ultimately, the c30% shareholding management team will probably seek some sort of exit to a strategic/ trade buyer. There has been some activity in the sector to support this