Axon's strategic vision focuses on obsoleting the bullet, reducing social conflict, enabling a fair and effective justice system, and promoting racial equity, diversity, and inclusion. The company's continuous innovation, driven by significant research and development investments, addresses some of society's most challenging problems. Axon's financial strategy centers on building highly recurring, profitable businesses through purposeful product innovation. The company operates through two segments: TASER, which leads the market in conducted electrical devices, and Software and Sensors, which offers integrated hardware and cloud-based solutions for managing digital evidence and enhancing law enforcement productivity.

The investment rationale for Axon is that the company has a strong history of innovation that has led to market dominance for supplying hardware and software to police departments. Even after growing sales by 28% annually over the decade, there continues to be a significant runway for continued growth through international expansions and additional software that could leverage AI. However, my valuation calculation indicates this stock is currently at fair value leaving no room for upside after a big beat-and-raise Q2’24 earnings report on August 6.

Business Description: Axon's TASER segment, which accounted for 39.2% of company-wide sales in 2023, focuses on developing smart devices, tools, and services that aid public safety officers in de-escalating situations, minimizing the use of force, and supporting consumer personal protection. This segment includes TASER devices, virtual reality (VR) training services, and consumer devices. In order to understand the progress and quality of Axon’s products, it’s helpful to move back in time to 1993, when Axon was founded.

Starting with the AIR TASER 34000, Axon initially targeted the civilian market. However, this product was ultimately deemed a failure because it relied on producing pain by stimulating sensory nerves. By overstimulating sensory nerves of the peripheral nervous system, the result is the body sends a signal of pain to the central nervous system, but the product didn’t directly impact the central nervous system. In order to really cause muscle contractions necessary for incapacitating an individual, you need to attack the central nervous system. Therefore, people with high pain tolerances could fight off the shock from the AIR TASER 34000. The issue comes down to the fact that it was engineered based on assumptions about how much electricity it would take to temporarily paralyze an individual. Founder and CEO Rick Smith said in the Moonshots and Mindset podcast:

“So what happened when we first launched our consumer Taser, we started having failures in demos where people could fight through it. And I had one catastrophe in Prague in the Czech Republic where I went to demo to their national police force and we had seven volunteers in a row. Nobody even fell down, they all fought through it. And so when we designed that first pig experiment…

We built a test rig where we could add one, two, three or four capacitors, one, two, three or four sets of batteries. And then we could ramp up or down the intensity using some pretty gross system adjustments. And just doing that experiment and then observing the muscle contractions of that pig, we were able to very quickly identify what we needed to change. And then from that came the first of now over 100 patents that have given us a huge IP portfolio.”

The TASER M26, introduced in 1999, represented a significant technological leap. The M26 introduced neuromuscular incapacitation (NMI) by stimulating both sensory and motor nerves. This innovation meant that the M26 not only caused pain but also disrupted voluntary muscle control by sending electrical pulses that interfered with the central nervous system. These pulses caused involuntary muscle contractions, effectively incapacitating the target regardless of their pain tolerance or motivation. The development was borne out of detailed experiments, which allowed Axon to correctly design a device for reliability. In addition, the M26 offered a maximum range of 25’, compared to the 15’ range of the initial TASER model 34000.

This was followed by the TASER X26 in 2003, which offered a more compact design with enhanced NMI effectiveness. The reduced size allowed officers to more easily carry them on a duty belt.

It wasn’t until 2009 that Axon launched the first taser with multiple shots, the TASER X3. Two years later the X2 further improved functionality with multi-cartridge capabilities and reduced size from the bulky X3 version. However, there were still concerns about reliability. This is largely because the TASER guns need to hit a target and land two barbed darts at least 12 inches apart on a body. If the two land too close, the electricity doesn’t flow reliability enough to incapacitate an attacker. Analysis by American Public Media (“APM”) found in 2019 that Tasers were unreliable up to 40% of the time.

The TASER 7, introduced in 2018, enhanced reliability through its two cartridge system with one optimized for close-quarter shots and the other for stand-off range. This is important because according to APM, most officers are shooting their taser from within six feet. However, the predecessor model, X2/X3, didn’t reach optimal spread until the target was at least nine feet away.

Axon launched its latest model, the TASER 10, in 2023. This model boasts an increased maximum range of 45 feet, which compares to all prior models that maxed out at 25 feet. It also holds 10 shots and further improved probe spread for reliability. This has been hailed as a game-changing device for Axon. And it’s also been the fastest to ramp up sales, according to Axon, with shipped units total 50K in its first year of 2023. The TASER 7 sold and shipped 49K units in 2019 after its launch in December 2018. Axon said in February it shipped 50K units of the Taser 10. However, the order rate for the first year of the Taser 10 was 4X higher than the first year of the Taser 7. This indicates that bookings far outpaced what Axon thought and while they can book the sales of Taser 10, they can’t ship the units and turn them into accounting revenue. Regardless, we can see sales of devices were up a solid 16.4% in 2023 to $333.9M. The following table strings together TASER segment sales dating back to 2013. Devices revenue increased at a compounded annual growth rate (“CAGR”) of 14.8% in the 10-year period of 2014 to 2023. What’s also astonishing is the sales of cartridges to refill TASERS brought in another $193.2M, which is nearly as much as the device itself. Cartridge sales increased at a CAGR rate of 19.6% in the past decade.

The other material line item you’ll notice from the table of decomposed sales is that Axon generated another $34.8M from Axon evidence and cloud services for TASER products. This is made up of cloud-connected devices to help track firing logs, and also virtual reality (“VR”) training for using TASER pistols.

President Joshua Isner said of VR in the May 2024 JPM TMT conference:

Police training is really, really hard on agencies logistically. You think of an agency, the size of New York Police, 40,000 officers; having to get all those offices through in-service training and not only get them through training, but make sure the training was worthwhile and that they retained all of the information and so forth. It's really hard to do that. And after a couple of hours or 6 hours of in-service training once a year to expect the police officers to fire TASER at an expert level with maximum accuracy and maximum comfort with the device, it's just -- it's a stretch to think that's enough training.

And so when you have VR and you can literally put a headset on and be practicing firing a TASER in VR every day and the controller is an actual TASER 10 or it's the same weight and feel of a TASER 10 and the aiming is the exact same as you would see in the field, all of a sudden, you can get way more proficient in using the weapon, and we think that is a very interesting way to further monetize the device when you're talking about maybe disrupting the training business as a whole in public safety. And we're building this platform to -- you'd be able to engage with all use of force tools, not only TASERs. So we think the TAM here is actually bigger than our TASER market in terms of when this thing hits scale.

In the competitive landscape for conducted energy devices (CEDs) like Axon's TASER, the company faces direct competition from a variety of less-lethal alternatives, including pepper spray, rubber bullets, stun guns, and other non-lethal tools used by law enforcement. Companies such as Byrna Technologies, SABRE Corporation, and Wrap Technologies Inc. produce products that serve as alternatives to TASERs. However, Axon has maintained a strong position by offering advanced technology, versatility, and low injury rates, which are critical for law enforcement agencies. Beyond competing products, one of the biggest challenges for Axon is the growing emphasis on de-escalation techniques, where police officers are increasingly trained to resolve confrontations through verbal communication and other non-physical means before resorting to any form of force, including TASERs. This shift, driven by new laws and public pressure, suggests that the use of TASERs may be less frequent as agencies focus on minimizing the need for force in interactions with the public.

The next frontier for Axon is the development and sale of drones. Axon already sells drones within the software and sensors segment, however, Axon is concurrently exploring taser-armed drones. This has been met with pushback, including by its own ethics board. Nine of the 12 members quit over their concerns of weaponized drones in 2022. In June 2023, Axon wound up acquiring Sky-Hero, one of the leading tactical drone makers for an undisclosed amount. Axon acquired another drone company, Dedrone, in May 2024. I’ve gotten ahead of myself here because these products will actually sit in the other business segment. But for ease of reading I’ll make sense of the drones here with a quote by Isner discussing Dedrone in the May 2024 conference call:

“Dedrone, which is a two-pronged business. Number one, they do all the drone mitigation in defense. So they take drones out of the sky that are harmful enemy drones. They track all drone traffic in the air. You can think about targets like stadiums or government facilities, correctional facilities. Those are the places that are deploying Dedrone to protect their infrastructure.

And then Dedrone also offers what we think will be hugely valuable in the future, which is a product called Beyond Visual Line of Sight for drones. So right now, there's an emerging part of public safety called DFR, which is Drone as a First Responder. So 911 call comes in, you dispatch a drone first. and get all the live video of what's going on at the scene. So as the officer arrives at the same, they have more situational awareness.

Well, the problem with doing that today is this person has to literally be watching the drone from start to finish. So they're passing it off on rooftops. You've got humans set up on rooftops, watching a drone fly until they can't see it anymore. And then the next person takes over watching the drone. It's kind of humorous that, that is the workflow right now for this use case. Well, Dedrone because they monitor all of these drones in the sky, you can actually apply and get a waiver to do DFR using Dedrone instead of using a human's line of sight. And so we think offerings like that will accelerate the pace at which drones are adopted and widen the use cases for which they're used in policing.”

With multiple drones assets being developed by Axon, you could say the sky is the limit for the TASER segment.

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The other segment for Axon encompasses Software and Sensors, and combined to make up the remaining 60.8% of company-wide revenue in 2023. This segment is known for making body cameras worn by police officers, in addition to in-car dash cameras. The flow of data from these devices prompted Axon to build out the software business to house all of the video and other insights into Evidence.com, its cloud-hosted software platform.

Let’s step back into time and look at how this segment came to be. Unlike the evolution timeline in the graphic below, which came from the Axon webpage title “Evolution of the Axon Body Camera”, Axon launched their first camera as an attachment to the TASER X26 in 2006. It was attached right under the handle of the TASER. The intention at the time was to specifically improve accountability in the use of their TASER product. However, starting the recording only when the TASER is unholstered captures just the intense moments of the police encounter, often missing crucial preceding interactions.

In 2009, Axon made a significant leap forward with the launch of its first body-worn camera, the AXON tactical computer, and its complementary cloud-based storage solution, Evidence.com. This marked a pivotal moment for the company, as it expanded its vision to enhance accountability and transparency in law enforcement. The AXON system consisted of three main components: the HeadCam, a lightweight headset camera designed to capture video from the officer's perspective; the Com Hub, a communication device linking the camera to the officer's radio; and the AXON tactical computer, a body-worn processor that stored the data and featured a 4.3-inch touchscreen for playback and audio reporting.

Initially, the system required agencies to download and manage the video data themselves, posing logistical challenges. However, with the introduction of Evidence.com, Axon provided a robust, offsite data storage solution that revolutionized how agencies handled digital evidence. Evidence.com allowed for secure, 128-bit encrypted storage, scalable to virtually limitless capacity, and offered features like incident marking and the Chief's Dashboard for supervisors to review footage efficiently. This integrated approach not only streamlined evidence management but also significantly improved officer accountability and safety, laying the groundwork for Axon's dominant position in the law enforcement technology market. As Rick Smith, Axon's CEO, explained, "We are expanding our vision to protect officers on the streets and in the courtroom until the last gavel drops."

In 2012, Axon introduced the AXON Flex, a video recording system designed to capture evidence from an officer’s perspective. The AXON Flex offered multiple mounting options, including integration with Oakley’s Flak Jacket eyewear, and featured Bluetooth streaming technology for real-time review on smartphones. While it provided flexibility and ease of use, its impact was limited compared to later models. The Flex camera’s durability and advanced imaging capabilities made it a step forward in wearable technology, but it primarily served as a transitional product leading to more significant innovations.

The next year, in 2013, Axon launched the AXON Body camera, which became a cornerstone of their product lineup. The AXON Body camera was designed for simplicity and affordability, priced at just $299, making high-quality video capture accessible to more agencies. Key features included a 130-degree wide-angle lens, 12-hour battery life, and low-light recording capabilities, providing a comprehensive view of officers' interactions throughout their shift. The camera's pre-event buffer captured 30 seconds of video before activation, ensuring critical moments were not missed. Videos were automatically uploaded to Evidence.com, Axon’s cloud-based storage platform, enhancing evidence management with secure, tamper-proof handling.

The widespread adoption of body cameras in law enforcement gained significant momentum following the 2014 killing of Michael Brown in Ferguson, Missouri. This incident, along with other high-profile police killings, sparked a national debate over policing practices and transparency. In response, many police departments across the United States began implementing body camera programs to increase accountability and rebuild trust with their communities. By 2016, nearly half of the country’s local police departments were using body cameras, driven by federal funding and a push for greater transparency. This surge in adoption was part of a broader movement towards reforming policing practices and addressing public concerns about excessive use of force and racial disparities. By 2020, the number increased to nearly 80%, according to Police Executive Research Forum.

In 2015, amid this increased focus on body camera adoption, Axon launched the Axon Body 2, a next-generation body camera designed to address the growing needs of law enforcement agencies. The Axon Body 2 featured advancements, including Retina HD video for superior low-light recording, a full-shift 12-hour battery life, and a pre-event buffer that captured up to 2 minutes before an event. Additionally, it introduced wireless activation through Axon Signal, which automatically turned the camera on with sensor activation, such as the use of light bars. This model further enhanced evidence management with features like in-field tagging and automatic evidence upload while recharging. Built to withstand extreme conditions, the Axon Body 2 ensured data security with encryption and provided versatile mounting options with RapidLock mounts.

Axon introduced the Axon Flex 2 in 2016, an upgrade to their original Flex body-worn camera. The Flex 2 featured enhanced mounting options, improved durability with a solid polymer casing, and a wider 120-degree field of view. It also offered HD video resolution and dual-channel audio, along with Axon Signal for automatic activation. Despite these advancements, the Flex 2 remained a smaller product for Axon, generating $10.1 million in revenue at its peak in 2017. The Flex line, while innovative, did not achieve the same widespread adoption as Axon's body camera series.

In 2018, Axon launched the Axon Body 3, marking a significant step forward in body camera technology. The Body 3 featured real-time situational awareness with live streaming capabilities and gunshot detection, significantly enhancing officer safety. It provided improved low-light capture, image clarity, and audio technology. The camera's LTE connectivity allowed for instant wireless evidence offload, reducing the need for docking and enabling immediate access to critical evidence. By 2022, the body camera line had generated $124.2 million in hardware sales, underscoring its importance to Axon's growth and paving the way for Axon Evidence.com. This platform provided a comprehensive digital evidence management solution, solidifying Axon's leadership in law enforcement technology.

In 2021, Axon held approximately 70% of the market share for body cameras, according to industry reports. This dominant position has drawn scrutiny from federal regulators, leading to complaints to the Federal Trade Commission (FTC) about Axon’s growing monopoly. The FTC alleged that Axon's acquisition of its largest competitor, VieVu, constituted anti-competitive behavior, resulting in higher prices and diminished services for police departments. The FTC's actions highlight a concern about Axon's market dominance on competition and law enforcement transparency. However, Axon continued to secure significant contracts with law enforcement agencies, due to its superior features and integrated bundling.

To catch us up to today, Axon continues to lead in body camera technology with the introduction of the Axon Body 4 in 2023. This latest model includes several advancements such as two-way communication, allowing officers to receive real-time support from their command centers, in addition to live streaming. It also offers the option to connect additional point-of-view cameras, providing multiple perspectives during critical incidents. There have also been other general improvements such as sharper image quality and a wider field of view.

In 2024, Axon expanded its market reach with the launch of Axon Body Workforce, a body camera tailored for frontline workers in retail and healthcare settings. This lightweight and customizable camera is designed to help de-escalate incidents and provide real-time support, similar to its law enforcement counterparts. Early trials have shown promising results, according to Axon, with significant reductions in incident escalations and improved safety for employees. Here’s a quote from CFO Brittany Bagley discussing the product and strategy from the March 2024 Morgan Stanley TMT conference:

“We also think there's an opportunity for nurses down the road. And the reason we think there's a big opportunity for retail associates and nurses is those are two environments where both sets of those employees feel quite unsafe in their work environment. And so the theory behind adding a potential body camera in is to de-escalate the situation, to have a single point of truth in any kind of interaction that is happening. And so Body Workforce is really meant to provide a camera that is easier for someone who isn't kitted out in full gear and wearing a vest and having a really comfortable place to put that camera to have an option to wear a camera.

So we just launched it. I'm sure we have a lot to learn about going into that space. But that is the idea is that they'll have something that is a little bit more comfortable, a little bit more sort of retail consumer-friendly to wear, and they will be able to decide that they can capture that interaction in our early trials, just having the camera results in de-escalation, like just somebody knowing that they are being filmed can sort of put a little pause on things. And so that's a big angle that we're going after.”

In 2014, Axon generated $13.8M from camera hardware, which is the first full year selling the body camera. 10 years later, in 2023, body camera and accessory sales totaled $183.0M for a CAGR of 33.3%.

The real story for Axon, financially, is actually evidence and the cloud services. Over the same 10-year period, Evidence.com grew revenue to $566.2M in 2023 from $4.0M in 2014. That’s an annual growth rate of 73.2%. Truly amazing considering it jumped by another +50% in 2023. As noted earlier, a little more than 80% of police officers wear body cameras so there isn’t much more growth available from the hardware. However, I do believe there’s still significant opportunity for Axon’s software services. This platform has already gone from a simple repository of visual data to a multi-pronged software offering that includes dispatch, records management, and soon insights and productivity via an AI layer.

For context, the additional offerings of the computer-aided dispatch, known commonly as “CAD”, and the records management system (“RMS”) are relatively new offerings. Axon launched the RMS solution in 2019 which natively integrated digital evidence, such as body cam footage, directly into incident records, allowing for a streamlined and efficient process. In 2022, the company launched Axon Dispatch, a robust CAD system built on modern cloud technologies. Axon Dispatch enhances 911 call centers by providing real-time notifications, modern mapping, and a seamless connection to critical data sources, thus improving response times and situational awareness. According to the August 2024 earnings call, management will instead pivot away from the holistic CAD system in favor of more niche solutions such as mapping and real-time video to plug into existing department processes. It seems the ROI is poor so trying to capture the CAD bundle as a whole isn’t worth it.

Axon's innovation in software solutions took another leap forward in 2024 with the introduction of Draft One, an AI-powered tool designed to draft high-quality police report narratives in seconds based on auto-transcribed body-worn camera audio. Draft One aims to significantly reduce the time officers spend on paperwork, allowing them to focus more on community engagement and personal well-being. As Axon CEO Patrick Smith stated in the May earnings call:

"Draft One leverages AI to produce police reports from body camera, audio and video. Our studies have found that officers in the U.S. spend about 40% of their time or 15 hours per week on what is essentially data entry, writing reports. This is valuable time they could be spending in their communities, with their families, in training or on their own well-being. With Draft One, we're giving them a new lifeline that we expect will save them critical hours each and every day...

This is the entire reason that we invested in a record management system 6, 7 years ago was entirely because we saw this coming, but the ability to not only have your video evidence and your written records in one system, but to be able to extract one from the other would be critical."

You piece it all together and Axon is now at the point where they can work within dispatch software for a department, capture and house immense data and efficiently port that into a records management system, with the next step being police officer productivity. Thinking about it this way, it’s easy to understand why evidence and cloud services continues to have a long runway.

In the competitive landscape of the body-worn camera and digital evidence management market, Axon has maintained a strong position. The latest freely available market share data pegged Axon at approximately 70% as of 2021. Axon's closest competitor, Motorola Solutions has been aggressively expanding its footprint in this sector. Motorola acquired WatchGuard in 2019, which at the time was the second largest body camera provider.

It’s unclear just how much revenue Motorola makes from body cameras. The product sits within video, a sub-segment of their software and services business. According to the latest Motorola 10-K, video has a whole generated about $515M in sales in 2023. That would include other types of cameras, though. Regardless, Motorola is clearly the number two player and there’s a wide margin to player number three. Similar to Axon, Motorola's strategy also includes bundling its body cameras with other security solutions like two-way radios and in-car systems to create a more integrated offering. Unlike body cameras, the market for records management and CAD is competitive and fragmented.

Axon identified more than 50 competitors in the RMS and CAD verticals, according to their 10-K, including well-established firms like Hexagon AB, Tyler Technologies , and Motorola, NICE Ltd. as well as numerous smaller players. Despite this fragmentation, Axon believes its network of camera sensors and digital evidence management platform provides a strategic advantage. For real-time operations, Axon competes with platforms that ingest body camera video feeds, such as Genetec's Citigraf and Motorola's CommandCentral Aware. Additionally, Axon Respond competes with platforms that exclusively handle surveillance camera feeds, such as Hexagon's Connect and Live Earth's Spatialitics GeoShield.

Financial Performance: Net sales in 2023 totaled $1.56B, up from $164.5M 10 years earlier, representing a compounded annual growth rate (“CAGR”) of 28.4%. Over the last decade, the weakest year for revenue grwth was 2014 when revenue increased 19.4% YoY. The last year in which revenue decreased was 2010 and there’s only been three years total since the 2001 IPO that revenue decreased. Overall, revenue growth has been consistently strong. In addition to the consistent revenue growth, company-wide gross margins have consistently been near 62% over the last decade.

Despite the relatively flat gross margin percentage over the past decade, the segment margins have evolved quite a bit. TASER’s gross margin has moved lower from 67.3% in 2014 to 60.5% in 2023. Conversely, the Software and Sensors segment has increased from 19.1% in 2014 to a record high 61.5% in 2023.

Digging deeper, the cost structure shows the cost of products sold (TASER and camera hardware) has been moving lower over the last decade. Cost of services delivered (largely cloud hosting costs), Sales and Marketing and Research and Development have each been inching higher. The most volatile component has been the General and Administrative cost due to stock-based compensation programs at Axon (more on that later). The 2023 R&D as a percent of revenue was 19.4% and Sales, General and Administrative (“SG&A”) as a percent of revenue was 31.8%. Most of the stock-based compensation, which represented 8.4% of revenue in 2023, sits within SG&A. As a comparison, Russell 1000 growth companies averaged 26.2% SG&A margin and 5.3% SBC margin. Axon is solidly higher than that broader group and closer to software companies. It’s borderline excessive.

Capital Allocation: Shifting to Axon’s capital allocation history. In a practical sense, companies can use their capital to reinvest back into the business, acquire other companies, pay dividends and buyback stock. Over the last decade, Axon generated $839M in cash from operations. Axon has never paid a dividend. Instead, it spent $289M on capital expenditures to invest back into the business, representing 35.5% of cash from operations. Spending on acquisitions has been modest at $76M, or 9.0% of cash from operations. According to Axon’s statement of cash flows, the largest component in the capital allocation framework has been stock buybacks which totaled $542M since 2014, equal to 64.6% of cash from operations.

Nearly all of the buybacks reported on the cash flow statement were actually in the form of stock withholdings associated with vestings for stock-based compensation. The volume of these buybacks isn’t selected by management but instead is based on the timing of vestings of performance stock. Of the total $542M in reported repurchases, only $64M were executed via open market plans since 2014 according to VerityData. The last time Axon was in the market for its shares was in Q2’16 as shares were recovering from a drawdown.

Another notable data point in Axon’s capital allocation history is their use of at-the-marketing (“ATM”) offerings, which are the opposite of open-market stock buybacks. In an ATM sale, the company coordinates with a broker and sells shares at their leisure based on the market price at that time. Axon entered into an ATM program in August 2021 and quickly began selling shares in Q3’21 (July to September 2021) at about $186, according to VerityData. Management picked a near-term high to sell the shares as the stock lost half its value within a year. Axon didn’t sell shares again until Q1’23 and Q2’23 which wasn’t as timely, but did precede some weakness in the months after. This shows me that management is aware of their stock’s valuation and attuned to when to sell equity.

The total sale of 1.0M shares through Axon’s ATM program added to high dilution from stock-based compensation. Axon’s shares outstanding increased to 75.3M at the close of 2023 from 52.5M in 2014 (up 43.4%). The dilution offset Axon’s growth in free cash flow (“FCF”) per share, which increased at a CAGR of 11.9% in the past decade. Without dilution of shares, FCF grew at a CAGR of 16.4% in the same period. However, valuation is done on a per-share basis so the metric that matters is the more tepid growth in FCF per share. This is another knock on the high stock-based compensation at Axon.

Management and Incentives: Axon was founded and has been led by Patrick “Rick” Smith as CEO since 1993. Smith was 22 years old at the time and Axon makes up all of his professional work experience. He’s the founder/CEO who sunk his entire life into Axon and its moonshot mission to reduce killings, largely through the TASER product. In fact, Axon was bootstrapped with funds from the outset from Smith’s father. Ever since then he’s been laser-focused on Axon and hasn’t even served on another company’s board.

The second in command at Axon is Josh Isner whose current title is president. Isner joined Axon in 2009 and made a name for himself in 2014 by leading body camera and software sales. By demonstrating a “track record of delivering results”, Isner was elevated to chief revenue officer in 2018 and then COO in 2022. Isner now broadly leads operations, marketing, policies and employees at Axon.

Brittany Bagley joined Axon as CFO in September 2022 and subsequently added the COO title. Before Axon, she was CFO of Sonos (SONO) from April 2019 until joining Axon 2.5 years later. Bagley spent the early portion of her career at Kohlberg Kravis Roberts (KKR) in private equity with a focus on technology.

The top five executives also includes Jeff Kunins, chief product and technology officer. Kunins joined Axon in 2019 and leads product and technology spanning both body cameras and taser weapons. Before Axon, Kunins held prominent roles at two Seattle-based technology companies - Amazon (AMZN) and Microsoft (MSFT). While at Amazon Kunins was VP of Alexa Entertainment and was VP of Amazon’s Kindle. Lastly, I’ll note that Axon recently hired Cameron Brooks as chief revenue officer in April 2024. Brooks is also an Amazon alumnus whose previous role was general manager of AWS sales for Europe, Middle East and Africa. This one caught my eye because international sales have lagged behind domestic sales. Axon is based in Scottsdale and nabbing a prominent CRO who can drive sales internationally is important. According to Isner, Brooks is based in Europe too. Isner in a May industry conference:

“I'm starting to get more and more excited about (international sales) and part of that is the arrival of our new CRO, who's based in Europe, and we'll be driving a lot of the future success of deploying the cloud into some of those major European police forces.”

The components of Axon’s compensation program are made up of an annual salary, annual bonus and stock-based compensation paid in the form of restricted stock units (“RSUs”) and performance-based XSUs. XSU is a term unique to Axon and stands for eXponential Stock Units. They’re akin to performance-based stock units (“PSUs”) elsewhere, though not given every year. I extracted the compensation data for the past six years for CEO Smith, President Isner, CFO Bagley and her predecessor, and CPO/CTO Kunins. Smith has unique compensation structure that essentially follows the Elon Musk playbook at Tesla . Smith may also be similar to Musk in stretching the truth, as discussed in this Reuters article that’s worth a read if you want to dig into corporate governance. Back to compensation. In 2018, Smith lowered his salary and bonus to the minimum amount and instead took an outsized stock award that was intended to cover his compensation for “up to 10 years”. I’ll cover the actual incentives in a bit, but first, I’ll touch on the ratio of pay.

In the six year period from 2018 to 2023, just 0.1% of CEO Smith’s compensation was paid in the form of a salary. He never received a bonus and his “other” compensation, made up of 401K contribution and life insurance premiums, were immaterial. 99.9% of his pay came from stock-based compensation. This ratio has a uniquely high weighting on stock-based compensation. Other named executive officers (“NEOs”) had 3.1% of total compensation paid in the form of salary, 7.7% from bonus and 88.9% in the form of stock. I like seeing the high ratio of pay paid in the form of stock because it’s the best way for management to have alignment with shareholders, however, the absolute dollar value of pay is relatively high at Axon. For instance, President Isner has averaged $11.5M in total pay in the past six years, which is solidly higher than the CEO of peer company Tyler Technologies (TYL). Having said that, management at Axon has beyond delivered in the past decade so you could still say shareholders are getting a lot of bang for their buck.

Now to the actual incentives. The annual cash bonus is weighted 80% toward company financial goals and 20% toward operational goals. The following table shows the weights for financial goals which is 30% revenue, 30% adjusted EBITDA, 20% new marketing bookings and 20% new product adoption. In February 2023, Axon gave initial full year 2023 guidance of revenue of $1.43B and 20% adjusted EBITDA. These match exactly what Axon used for the target goals for compensation which is a nice and clean way of setting the goals. Management gets 100% of their bonus for meeting the guidance laid out to shareholders at the time.

The operational goals are related to “regrettable attrition” and “Company values”. Isner has an additional KPI related to company engagement.

Next I’ll discuss incentives for stock-based compensation though it’s quite complicated with multiple plans running so I’ll leave out some details. As noted earlier, Axon doled out a massive stock award in 2018 valued at $246.0M to CEO Smith. This was a Tesla style vesting as it had 12 market-cap tranches with additional revenue and adjusted EBITDA goals. The table below shows the eight revenue and eight adjusted EBITDA goals. Axon needed to clear the market-cap goals that ranged from $2.5B to $13.5B ($1.0B increments for each tranche) and financial goals (either revenue or adjusted EBITDA). For context, Axon did $1.56B in revenue and $329M in adjusted EBITDA so they clear nearly all the revenue goals, all the adjusted EBITDA and easily cleared all the market-cap goals.

A year after giving CEO Smith the special award, Axon approved the 2019 eXponential Stock Performance Plan (“XSPP”) for other executives with identical performance criteria to the CEO plan. One significant difference between the NEOs and CEO is that the NEOs still received annual RSUs payments so that means the NEOs were guaranteed some value regardless of financial and stock performance.

Fast forward to May 2024, shareholders approved a new 2024 CEO Performance Award and 2024 eXponential Stock Plan (XSP 2.0). The financial and stock price hurdles are the same for the CEO award and XSP award for other executives, except the minimum service date is slightly later. Anyway, the notable data points to key in on are that the highest revenue hurdle is $6.999B, the highest adjusted EBITDA goal is $1.75B, and the highest stock price hurdle is $943.75. Axon has until 2032 to reach these hurdles so it’s not necessarily one per year. The initial stock price hurdle is $247.40 and each additional hurdle requires 25% additional appreciation so this is harder than the previous award that required $1.0B in additional market cap gain (meaning each hurdle gets smaller on a percentage basis). The difficulty of the financial goals for the 2024 plan is similar to the 2018 plan.

I like the aspirational stock and financial targets laid by Axon for their managers. This has been working as an incentive for management in the past decade. However, I don’t like seeing the level of compensation this high for a ~$20B company with the CEO receiving ~$200M in stock every six years.

Outlook: Axon last reported earnings on August 6 and gave full year 2024 guidance of $2.025B (midpoint), up 29.5% year-over-year (“YoY”). Management also generally gives a three-year longer-term financial guidance, and right now is targeting at least 20% annual revenue growth. The goal for adjusted EBITDA (excluding stock-based compensation) is 25%, which compares to the current adjusted EBITDA margin of ~23%.

When painting a picture of the longer-term outlook for Axon over the next five to 10-years, there’s a lot to be excited about. There’s three areas for Axon to expand into that could help the company 5X revenue in the next decade. 1) leveraging AI to enhance police officer productivity, 2) penetrating into non-core customers which is international and U.S. federal, and 3) drones.

As discussed in the business description section, Axon rolled out Draft One, an AI writing tool that uses body camera transcriptions to write reports. This is the perfect starter use of AI within Axon. According to the last earnings call, CEO Smith said customers’ response to Draft One is “better than anything I’ve seen”. Isner added:

“In the three months since launch, Draft One has generated over $100 million of pipeline, the fastest of any Axon software product to do so.”

The second order effect of Draft One is that it can bring more customers into cloud use. According to CEO Smith, reactions in Europe were compelling enough to interest customers into cloud use.

“when you think about the complexity of deploying AI at scale and the massive GPU clusters you're going to need and the connectivity into the cloud just eases all that. So, we've been almost religious about our cloud forever.

In the US, our customers told us early on the cloud was illegal, and they couldn't do it. Of course, we pressed through that, and now it's become ubiquitous. Europe has been harder. They've been very resistant to the cloud, and we've stuck to our guns, but it's taken a lot longer than we thought.

I think this is still theory. We haven't seen it paradigm, but the early reactions are AI services like Draft One and some of the new stuff you'll see in a few months could be enough to tip it over and start to make the cloud sweep through the rest of the world that's been very resistant to it. That will be a real game changer if that pans out.”

Concurrently, international bookings increased 100% during Q2’24. This is important to see because international sales have lagged domestic sales by only making up 14% of total sales. In 2023, $1.38B in revenue came from the United States while just $225M came from other countries. This has been exacerbated in the past two years due to relatively modest revenue increases internationally of about 13% while the United States had ~40% growth in each 2022 and 2023. That could begin to reverse, however, given the outperformance of international growth in Q2’24. Axon said international sales increased 49% YoY, solidly higher than the company-wide growth of 35%.

According to Axon, the total addressable market (“TAM”) for international business $26B so it will be important to see Axon grow globally beyond the core U.S. state and local departments that hold a TAM of $17B. I don’t necessarily trust the TAM and penetration numbers themselves but I do believe there’s a big untapped opportunity for international customers and Axon so far hasn’t penetrated well, often citing difficulty in selling the idea of cloud storage compared to domestic customers.

After AI integrations and international expansion, the next leg of the stool for long-term growth could be drones. There’s a big Federal Aviation Administration (“FAA”) hurdle for deploying drones out-of-sight and so Axon likely won’t sell a material amount of drones for real-time operations until another 10-years. But there could be a one-to-one ratio of police cars if departments are allowed to deploy drones as first responders. Recall, this is about providing the officer additional eyes and awareness before arriving to a scene.

A bonus long-term growth drive could also be personal protection. When CEO smith was on the Moonshot podcast he mentioned the Mars idea being cutting deaths in the general public through consumers opting for tasers instead of guns. If the technology gets good enough, there could be significant growth. A fun way to think about it is the futuristic sense like Phaser guns in Star Trek. Perhaps that becomes a reality when humans stun each through sophisticated taser-like guns. Smith’s remarks:

“Our belief was once we proved that [tasers] worked in policing, then consumers would follow suit. And there's actually some great case studies. The Glock handgun, the Maglite flashlight did similar things where consumers would then buy what the pros are using. Now since then, we've found a great market in policing, and our current moonshot is to cut gun deaths in policing.

But our Mars shot that comes after this is to cut gun deaths in the general public. But first, we've got to win in policing….

So once we get there, and that's what we'll do by the end of this decade, then watch us. We're going to pivot and then go into the consumer space. And I think for most consumers as well, hey, if you don't have to take a decision to take somebody's life in that moment when you want to stop a threat, that is just a huge advantage. You know, morally and legally and from a liability perspective.”

Now for the risk to this outlook. There’s legal and regulatory risks of the use of force for taser weapons. Despite the taser being a smaller and smaller piece of the pie, the taser is a good entry point for the sales team and the beginning of the flywheel to get more products into a department. Local governments will need to be lenient in allowing officers to use tasers for the business to grow. Another risk is the failure of international growth to materialize. Lastly, there are broader political risk and uncertainty due to trends such as Defund the Police, and it’s unclear what the next president of the United States will bring to the table. I think the pendulum is swinging away from the Defund the Police. Axon will need to see departments continue to grow their budgets in order to continue to upsell more products such as AI and operations software.

Valuation: To value Axon's shares, I built a five-year discounted cash flow model. I prefer five years because it’s difficult to forecast anything longer than that (even five years can be quite unpredictable). But five years is generally long enough to capture some change in growth trends. However, Axon could very well be a high growth company for the whole five years.

The DCF model starts out with forecasted revenue growth of 30.5%, which is just above the street consensus estimate. There’s a gradual slow-down in company-wide revenue growth through year five when 2028 revenue is expected to be $4,477M. This model reflects my base case, and there’s admittedly a lot of potential variation here to gain ~$3.0B in additional revenue in five years from the base of $1.6B in 2023. We’ll likely need to see a few years where international revenue is growing +50% annually.

I opted to use adjusted EBITDA rather than reported EBITDA. I’m projecting an adjusted EBITDA margin of 22.5% in 2024, and a linear path of 100 basis points in margin leverage added each year. My thinking here is that there’s a path to higher margins for the TASER segment, which was relatively poor in 2023, and the Software and Sensors segment has consistently improved profit margins over the last decade as more of the revenue comes from the high margin software business. By year five, Axon could generate an adjusted EBITDA of $1,186M. Recall the 2024 performance stock package had seven hurdles, and this financial forecast would see Axon complete five of the seven hurdles. Again, those seven hurdles don’t necessarily line up in annual fashion since the company has 10-years to meet the thresholds.

Because this DCF used adjusted EBITDA (excludes stock-based compensation), I had to add back in the stock-based compensation impact by including dilution. I’m taking a simple path with average annual dilution of 3.0%, so the equity waterfall assumes an outstanding share count of roughly 88M shares.

Other pertinent inputs include a weighted average cost of capital (“WACC”) of 8.0% (see below screenshot for build-up). The terminal exit multiple of 50X EV/EBITDA is against EBITDA of $828M, or adjusted EBITDA less 8% margin for stock-based compensation. For market fairness, the multiple does not use adjusted EBITDA. 50X is fairly elevated, though my comparison was Tyler Technologies which has an average EV/EBITDA of 59X in the last five years and Axon has significantly outperformed Tyler. The summary output calculates fair value of $362.00, about 3% below the current market price.

Conclusion: Axon has been the most fun and compelling company I’ve researched so far. They have a history of excellent execution and their CEO and other managers have made Axon a captivating story. And stories help sell a high valuation. Even though I’m pricing in ~23% top-line revenue growth over the next five years, the valuation still seems too high for me and I don’t think I could comfortably underwrite a higher multiple here to call this undervalued. Therefore, it seems the market is correctly pricing in material international, AI integrations and new potential lines. Despite the rich valuation, it’s certainly not a company I would bet against because the sky is the limit for Axon.

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Disclaimer: The content of this report is for informational and research purposes only and should not be construed as financial advice. The views expressed are my own and do not reflect those of my employer. While care has been taken in preparing this report, I make no representations or warranties of any kind regarding its accuracy or completeness. I currently hold no position in any stock mentioned. However, like any financial analyst, my perspectives may carry inherent biases. Readers are encouraged to conduct their own due diligence.

Littelfuse's business is structured around three primary segments: Electronics, Transportation, and Industrial. These segments collectively underscore the company's diversified approach, with the Electronics segment leading in both revenue and operating profit, accounting for 57% of 2023 revenue and 83% of the operating profit. This segment showcases Littelfuse's impact on empowering electrification, energy efficiency, and digital connectivity. Meanwhile, the Transportation and Industrial segments, though smaller in revenue contribution, are critical in advancing the company's strategic initiatives in eMobility, electrification, and sustainability, illustrating a balanced portfolio that addresses the evolving needs of a connected and safer world. Despite the business segment split up, Littelfuse collectively serves a balanced blend of end markets, seen in the graphic below.

The company's strategic positioning within these segments leverages long-term secular growth themes of sustainability, connectivity, and safety. This approach has not only solidified Littelfuse's role as a critical partner in enabling its customers' applications towards a more sustainable and interconnected world but has also ensured a steady demand for its products. From electrification and automation in the Electronics markets to eMobility and electronification in Transportation, and advancements in renewable energy sources and safety automation within the Industrial segment, Littelfuse's product portfolio addresses the increasing complexity and growing demands of modern applications.

The investment rationale in Littelfuse is formed by a strong organic growth outlook due to notable secular trends of electrification and renewable energy. Higher energy needs for infrastructure will call for greater circuit protection. In addition, Littelfuse’s growing power semiconductor business offers another avenue of growth due to electrification. Management of Littelfuse has a good history of amplifying growth through acquisitions that have helped create shareholder value, another compelling facet of the investment rationale. My present valuation calculations implies upside of 26% to the current stock price.

The rest of this analysis will cover Littelfuse by providing an overview of the business, an examination of the capital allocation history, management and their incentives, capped with an outlook and valuation.

Business Overview: The first segment we'll explore is the Electronics segment, which is the largest of Littelfuse's three segments. With an extensive range of products, this segment caters to a wide array of end markets, from automotive electronics and electric vehicles to data centers, medical devices, and more, underscoring its pivotal position in powering and protecting today's increasingly digital and electrified world.

At the heart of the Electronics segment are legacy products and innovative technologies designed for circuit protection, power control, and sensing. These are vital for safeguarding electronic systems against common hazards such as voltage spikes, short circuits, and electrostatic discharge. Among the passive protection components, transient voltage suppressor (TVS) diodes and arrays protect against brief voltage spikes, while positive temperature coefficient (PTC) resettable fuses, a legacy product, can recover from overcurrent conditions without needing replacement, reducing maintenance. Additionally, electrostatic discharge (ESD) suppressors provide crucial protection for sensitive electronics against sudden electrical charges. These passive components, including traditional fuses and related accessories, represent the foundational technologies of Littelfuse, reflecting their long-standing expertise in circuit protection.

Littelfuse has been shifting the Electronics segment’s offering more toward power semiconductors, which help manage the efficiency and reliability of energy conversion and distribution. These are critical in high-power applications and are essential for demanding applications that require robust energy management, such as in renewable energy systems and industrial motor drives. This category includes advanced technologies like Silicon Carbide (SiC) and Metal-Oxide-Semiconductor Field-Effect Transistors (MOSFETs), and Insulated Gate Bipolar Transistors (IGBTs). The integration of these high-performance semiconductors ensures that the Electronics segment leads in developing solutions that enhance the reliability, safety and longevity of end-user applications. The simplest way to think about the Electronic segments offerings is that Littelfuse is providing solutions to safely stop electricity through circuit protection and fuses, and also starting/stopping electricity flow through the power semiconductors.

Littelfuse has historically provided quarterly GAAP (reported) sales growth, and also growth attributed to M&A, divestitures, Foreign exchange, and other line items to better gauge operating performance. I was able to use tables back to 2016 to analyze and separate organic growth from acquisition-driven growth.

For the Electronics segment, reported revenue grew at a compounded annual growth rate (“CAGR”) of 14.2% since 2016. That can be decomposed to 4.1% from organic growth and 10.9% M&A, so clearly the segment has been fueled by acquisitions. Littelfuse also disclosures operating income (EBIT) for each of its segments. The Electronic segment has almost always had the highest operating profit margin, despite the fluctuations. The operating profit margin for this segment stood at 21.2% in 2014 and over the last 10 years it moved as high as 28.9% in 2022 before regressing back to 22.3% in 2023. The recent drop was driven by a reduction in revenue “mainly due to lower volume from the Electronics products business driven by inventory rebalancing at certain distributors and reduced demand across certain electronics markets, including consumer facing and personal electronics, and telecom,” according to the 10-K.

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The next segment to explore is the Transportation segment at Littelfuse, which caters to a wide spectrum of vehicle types and applications, from passenger vehicles to heavy-duty trucks and construction equipment. This segment has historically focused the least on acquisitions and has shown modest growth, reflecting a more conservative expansion strategy within the company's portfolio.

Littelfuse's transportation products encompass a variety of circuit protection, power control, and sensing technologies essential for the safety and efficiency of vehicles. These technologies are particularly necessary in a world increasingly leaning towards hybrid and electric vehicles. For instance, blade fuses, which are thin metal strips enclosed in plastic, protect circuits by melting and breaking the circuit when too much current flows through. High-current and high-voltage fuses are designed to handle larger loads, crucial for safeguarding components in electric vehicles.

Resettable fuses, another innovative component, can restore themselves after an overcurrent event, providing ongoing protection without the need for replacement. This is particularly useful in applications where maintenance access is challenging or where frequent fuse replacement would be disruptive. Sensor products within this segment monitor various vehicle conditions—from occupant safety to environmental parameters—ensuring both functionality and compliance with safety standards.

The acquisition of Carling Technologies in 2021 enhanced Littelfuse's capabilities in the commercial vehicle markets by adding robust switching, circuit protection, and power distribution products to its offerings. The strategic move was aimed at bolstering the company's portfolio and strengthening its market presence, particularly in sectors that are increasingly relying on advanced technology solutions. It also makes the revenue bars in the chat below stand out by driving growth. Since 2016, though, the Transportation segment had revenue CAGR of 7.3%. That can be decomposed as 1.3% from organic growth and 6.3% from M&A. When you look at the past decade, a disappointing attribute is the gradual decline in EBIT margins which was 13.9% in 2014 and only 5.0% in 2023. 2023 revenue declined by 5% “largely driven by reduced demand largely due to inventory rebalancing at certain distributors and customers, and some demand reduction in commercial vehicle end markets.” This lower volume directly impacted profit margins for the segment.

The third and last segment to discuss is the Industrial segment, which has shown the strongest performance over the last decade. This segment’s range of products is geared towards ensuring safety and efficiency in heavy-duty industrial applications. Industrial segment products include industrial circuit protection devices such as fuses, which serve to protect circuits by interrupting excess currents and preventing damage to equipment. The segment also features industrial controls like protection relays and contactors. Protection relays monitor for abnormal or fault conditions and activate mitigation actions, whereas contactors are specialized switches used to handle high power loads. Transformers, another critical component, are devices that transfer electrical energy between two or more circuits through electromagnetic induction, essential for voltage regulation across various industrial systems.

Ground fault circuit interrupters (GFCIs) and residual current devices are designed to protect against electrical shock by breaking the circuit when a fault current to ground is detected. Similarly, residual current monitors provide ongoing surveillance of electrical networks to ensure safety and compliance with regulatory standards. Arc fault detection devices enhance safety by identifying and interrupting arcing faults, which can be a fire risk in electrical systems.

Recent acquisitions, such as Hartland and Western Automation, have bolstered Littelfuse’s offerings in contactors, transformers, and shock protection devices, particularly enhancing applications in HVAC systems and e-Mobility charging infrastructure. Through these strategic expansions and its robust distribution network, Littelfuse is well-positioned to continue its growth trajectory in the Industrial segment, leveraging advanced technologies in industrial safety, renewable energy, and EV infrastructure.

As for financial performance, the revenue CAGR since 2016 stands at 17.9%. Organic revenue growth was a solid 9.7% and growth from M&A was 10.8%. Profit margins have been volatile for the Industrial segment and haven’t evolved in a particular direction, with an average of 13.1% in the past decade.

Before discussing company-wide financial performance, it will be helpful for me to first cover Littelfuse's business strategy. Littelfuse announced a five-year strategic plan in 2021 that aims to harness the global mega trends of sustainability, connectivity, and safety. These themes are central to driving increased demand for Littelfuse's products across its diverse markets.

The company targets average annual organic sales growth and growth from strategic acquisitions each in the range of 5-7%, which matches the growth objectives of the prior five-year plan announced in 2016. To achieve these goals, Littelfuse focuses on increasing product content with both existing and new customers, expanding its market presence into high-growth geographies and niche applications, and leveraging its comprehensive go-to-market strategies. The strategy also emphasizes enhancing commercial and operational excellence to improve profitability and margins.

Investments in innovation, customer-driven solutions, and digital infrastructure are key to adapting to the converging technologies across Littelfuse's segments. The company plans to sustain double-digit sales growth and superior profitability through a disciplined capital allocation strategy. This includes targeting a return of 40% of free cash flow to shareholders and reinvesting the remainder in strategic acquisitions that align with Littelfuse's long-term objectives. This approach is designed to deliver top-tier shareholder returns by combining robust growth with careful investment and resource management.

Those financial targets have generally worked for Littelfuse. Since 2016, the company-wide revenue CAGR 12.2% through 2023. That can be decomposed as 4% from organic growth and 9.3% from M&A. Just like the segment data I shared, those two numbers don’t add to 12.2% because the difference is from divestitures and Fx change. Had it not been for the poor financial results in 2023, organic growth and overall reported growth would’ve been higher. Through 2022 organic CAGR was 6.5% and 15.5% all-in including M&A. My sense is the long-term average for Littelfuse is about 5% organic and about 7% from M&A. I’ll note that the GAAP revenue CAGR since 2012 is 12.2%. Here’s an old comment from CFO Meenal Sethna in a December 2018 conference call:

"Our strategy is largely unchanged since 2012. It's been a continuation, little bit of an evolution, hasn't really changed dramatically since then. I would say the same thing about our financial commitments as it relates to the strategy. The first one I would start out with, you heard Dave talk about it double-digit sales growth, right? It's a combination of both an accelerated organic revenue growth. I say accelerated because historically, we have been in the 4% or 5% range on organic growth and when we updated our strategy in 2016, we felt the portfolio that we had built through acquisitions, through the diversity of the portfolio enabled us to grow faster than we've been growing previously in the 5% to 7% range organically. In addition to that, complementing it with 5% to 7% on average annualized growth on sales from acquisitions”.

Shifting to the margin profile of Littelfuse. The average operating profit (EBIT) over the last decade is 15.4%, with slight improvement over time. It was as low as 11.2% in 2020 and as high as 19.9% in 2022. Generally the margin has ebbed and flowed with volume, with a particular correlation to organic annual sales growth. When discussing the Electronics and Transportation segments I noted that sales were down in 2023 due to weak demand and bloated channel inventories that needed to be rebalanced. Those two segments, especially the Electronics segment, dragged down company-wide revenue and thus lowered the operating profit margin to 15.3% in 2023 from 19.9% in 2022.

An effective way to gauge whether too much inventory is building up is by using the inventory turnover ratio or Days Inventory Outstanding (“DIO”). These metrics are inverses of one another, and DIO is expressed in days, which is more digestible, so we’ll look at that here. Last quarter, Littelfuse held its inventory for 121.8 days before selling it. That’s down from a year ago, but still well above the 10-year average of ~90. As you can see on the chart below, there’s been a general long-term trend of increasing its inventory and Littelfuse should work to re-adjust their inventory balance.

For context of Littelfuse managing their inventory level, here’s a quote from CFO Meenal Sethna from the November 2023 earnings call that points out Littelfuse is selling more directly to customers and therefore holding more inventory.

“We are running at about 115-ish days or so of inventory on hand, but they are targets somewhere 100, maybe a little bit more than 100 days of inventory on hand.

The biggest change for us… is our business has evolved versus pre-pandemic times, there's different mix, some of which have longer lead time. And as we continue to grow our OEM-related business, where we're holding a lot of our own inventory also that adds a little bit more. So I would say, our target may be a little higher than historical, but at the same time, we've got more progress that we can make that's going to help us from a cash generation, still going into the end of the year and going into 2024.

So I'm pretty pleased with where we are, the progress we've made and where we're heading.”

Unfortunately, the inventory issue isn’t just Littelfuse’s own inventory, but also their distribution partners and end customers. According to the 10-K, Arrow Electronics is the largest distributor, accounting for 11.2% of sales in 2023, down from 11.5% in the prior year. (The customer section of the filing says no other customer accounted for more than 10% of sales.) For Arrow, their days of inventory outstanding was 74.1 last quarter, which is also quite elevated compared to the 10-year average of 50.6.

According to Littelfuse CEO David Heinzmann, excess channel inventory is nearly complete. Heinzmann said in the January 2024 earnings call Littelfuse made their way through 70% of the excess inventory and more recently in the May 1 earnings call he said they’re through 85% so the company is only another quarter or two away from fully digesting excess inventory.

It should be noted that this time last year, Heinzmann said in the February 2023 earnings call that the excess inventory would be worked through by Q2’23, so he was quite early in that prediction since it’s ongoing into 2024. Regardless, it should be noted that Littelfuse, their channel partners and customers have more work to do to bring down inventory levels.

Competition: According to the 10-K, Littelfuse operates in a competitive space with several larger and well-established companies. In the Electronics segment, for example, Littelfuse competes with notable companies like Eaton Corporation (ETN), which offers a comprehensive range of electrical components. This segment also sees Littelfuse competing with specialized semiconductor firms such as ON Semiconductor Corporation (ON), STMicroelectronics NV (STM), and Infineon Technologies AG (IFNNY), which focus on components critical for power management and efficiency. Littelfuse’s offerings, particularly in innovative and high-efficiency silicon carbide (SiC) technologies, position it to leverage growth trends in areas like electric vehicles and renewable energy systems, which are central to the power semiconductor industry's expansion.

Littelfuse aligns strongly with the industry dynamics emphasized in reports by Sky Quest and Mordor Intelligence. According to Sky Quest, the increasing vehicle electrification and clean energy production, alongside the reduction of carbon emissions, are propelling the power semiconductor market forward, a space where Littelfuse leaned into through their expertise in SiC technologies and other power control components. Similarly, Mordor Intelligence underscores the market's acceleration due to the robust adoption of electric vehicles and advancements in power electronics, which dovetails with Littelfuse's strategic emphasis on eMobility and efficient energy management solutions. The company's focus on power-efficient electronic devices and its investment in innovative power semiconductor components should help it capitalize on the escalating demand within the automotive sector and beyond. As the global market gravitates toward a more energy-efficient and environmentally conscious landscape, Littelfuse's product offerings and technological competencies demonstrate a clear alignment with the top themes and drivers shaping the power semiconductor industry today.

In the Transportation segment, Littelfuse competes with Amphenol Corporation (APH) and TE Connectivity Ltd. (TEL), both of which provide a range of solutions for vehicle electrification and connectivity, emphasizing the industry's move towards more electric and hybrid vehicles. Sensata Technologies Holding NV (ST), another key competitor, offers sensors and controls that are integral to advanced vehicle systems.

The Industrial segment, although Littelfuse is smaller in scale compared to some of its competitors, competes effectively due to its focus on niche areas. Again, Eaton is a competitor for the Industrial segment and Littelfuse also competes against General Electric's GE Multilin division.

Littelfuse's strategy to counteract the resource advantage of larger competitors includes focusing on customer-centric innovation, technical support, and strategic acquisitions that strengthen its product portfolio. While the market cap of Littelfuse is around $6 billion, smaller than the median of about $30 billion among its named competitors, this allows for agility and specialized attention to market niches where it can lead and expand.

The company’s strategic position is not just about competing on scale but also on the differentiation of its products, the quality of its customer service, and its ability to deliver reliable and safe products across its market segments. This approach, paired with a strong customer loyalty indicated by a healthy Net Promoter Score, bolsters Littelfuse's position in its competitive market.

Overall, there isn’t a direct peer for Littelfuse. Eaton makes products that compete against Littelfuse essentially across the board. But Eaton sports a ~$130B market cap and therefore manages the business differently than Littelfuse. Elsewhere, electronic component makers focus on becoming dominant in market niches, just like Littelfuse. Here’s a quote from CEO David Heinzmann in the May 2023 Oppenheimer Industrial Growth Conference:

“Quite frankly, as our business is pretty diverse. And even by segment, if you look by segment, we don't have singular significant competitors in a segment because our segments have a pretty broad offering of technologies across those segments. And each one of those sets of technologies tends to have a unique set of competitors. So we've built out this portfolio of technologies and even in-market applications we're focused on. And in most cases, we would be one of the market leaders within that space.

So as an example, in our legacy fuse business, we would have even different competitors in each of the 3 segments between Electronics, Automotive and Transportation as well as Industrial, but we would be a leader in each one of those markets. So if we think about like our Electronics Passive business, we would be the market leader or at least top 2 in each category of technology that we have in that offering.

In our protection semiconductor business, also, we see that where we're #1 or #2 kind of neck and neck there as well. Passenger car, circuit protection business, we're clearly the leader. As you talked about in Industrial, we've identified some specific applications and technologies where we're building up leadership within them, maybe not the full breadth of the Industrial segment yet. So as a whole, we really identify niches, where we can create unique value and really become a market leader from a technology and an application understanding. So it's a very broad set of competitors that we deal with.”

Among those competitors, Eaton is the most interesting comparable due to the strong overlap. Eaton is more than 20X larger than Littelfuse and it has outperformed Littelfuse materially over the past decade.

This has been attributed to Eaton’s strategic focus on high-growth, high-margin markets, effective cost management, and divestitures of low-growth, low-margin businesses. The chart below shows annual EBITDA margins for the two companies, according to Koyfin. Littelfuse’s EBITDA margin started at 21.7% in 2014 and ended at 21.8% in 2023, with no gain during the decade. However, Eaton showed steady improvement in its EBITDA margin, increasing from 15.9% in 2014 to 21.0% in 2023.

While many electronic component companies, including Littelfuse, saw their revenue decline in 2023, Eaton was able to grow revenue and margins in 2023. Eaton’s 10-K said “Organic sales increased 12% in 2023 due to strength in commercial & institutional, utility, industrial, and data center end-markets in the Electrical Americas and Electrical Global business segments, strength in sales to commercial OEM and aftermarket in the Aerospace business segment, strength in the North American, European, and Asia Pacific regions in the Vehicle business segment, and the ramp up of key programs in the eMobility business segment due to robust demand for electric vehicles.”

For Littelfuse shares to catch up to Eaton’s shares, Littelfuse's management will need to lean more on high-growth markets that are working for Eaton, such as data center power management products. It’s reasonable to expect Littelfuse to capture a portion of the growing data center demand. In January, CEO Heinzmann pointed out that there were “multiple data center wins in the quarter across technology offerings, including switches and fuses. Long term, we believe the use of artificial intelligence and computing will drive strong demand for our products in data center applications.”

Capital Allocation: The four main buckets of capital allocation are 1) internal growth via capital expenditures (cash flow statement item) and research and development investments (income statement item); 2) external growth by buying other companies; 3) dividends; and 4) stock buybacks. Management has the discretion to change spending habits in each category and Littelfuse has dynamically included all categories at different times.

Over the last 10 years (2014 to 2023), Littelfuse generated $2.9B in cash from operations. About $660M was spent on CapEx (23.2% of cash from operations), $400M was spent on dividends (14.2%), $230M was spent on share buybacks (8.1%) and the largest category for Littelfuse was M&A for which they spent a little over $2.0B (71.7%), according to cash flow statements.

For context, the internal investment by spending 23.2% of its cash from operations is squarely in-line with peers in the space. In addition, Littelfuse’s internal investment in research & development is also squarely medium. About 4% of revenue was directed toward R&D over the last decade and the 2023 figure of 4.3% is the exact median compared to its competitors.

The return of capital via dividends and buybacks has been modest and opportunistic. Notably, Littelfuse returned to modest buybacks in Q1’24 for the first in four years with shares languishing this year. The last time Littelfuse was buying back shares was in Q1’20 during a pullback, and overall their track record is timely. I’ll add that during the May 1 conference call CFO Meenal Sethna pointed out in her prepared remarks that Littelfuse picked up the pace of buybacks slightly in Q2’24:

“During the second quarter, we've repurchased an additional $23 million in shares through last Friday. We also announced yesterday that our Board approved a new 3-year $300 million stock buyback authorization effective May 1. We will continue to assess periodic share buybacks. Especially when we believe our valuation doesn't reflect our continued confidence in our long-term growth strategy.”

The biggest component of the capital allocation framework is the consistent spending on acquisitions. For 2023, Littelfuse spent nearly $200M on a pair of acquisitions, with most of it on Western Automation, a maker of electrical shock protection devices. Western Automation’s end markets are EV off-board charging (fast charging) infrastructure and other renewables.

2022 was Littelfuse’s biggest year for M&A spend driven by the purchase of C&K Switches for $540M. C&K is a maker of switches and interconnect product, which connect and transmit signals to various electronic components. Their end markets are broad and at the time C&K had $200M in annualized sales (2.7X price-to-sales ratio). Littelfuse and C&K are similar companies so there was natural synergies. CEO Heinzmann talked about the merger in an August 2022 earnings call:

“The combination of our companies significantly expands our technologies and capabilities enabling us to deliver a comprehensive solutions offering to our broad customer base. C&K enhances our technical and application expertise, engineering and designing capabilities, and our technology leadership and high-precision manufacturing, miniaturization and haptics. Our businesses are highly complementary and enable us to leverage our selective partnerships with distribution channels, OEM relationships and global footprints, including expanded capabilities in India and Vietnam. The integration is underway, and we look forward to leveraging our respective strengths.”

In 2021, Littelfuse made two material purchases by acquiring Carling for $315.5M and Hartland for $111M. Carling’s focus is on switches and circuit protection technology in the transportation space. They had $170M in revenue at the time making (1.9X price-to-sales ratio). Hartland’s focus was electronic components within HVAC and had $70M in revenue (1.6X price-to-sales ratio).

Littelfuse’s largest acquisition was for IXYS (former ticker IXYS) in 2018 for total consideration of $856.6M. The merger was paid for in cash and stock with $380.6M paid in cash and the remaining $434.2M paid in the form of Littelfuse stock, which caused the only jump in the shares outstanding. In the 12 months before the acquisition, IXYS generated $325M in sales making for a 2.6X price-to-sales ratio. IXYS was a maker of medium to high voltage power semiconductors across various end markets. This bolstered Littelfuse’s presence in power semiconductors after two material acquisitions in 2016, one being assets from ON Semiconductor. CEO Heinzmann said at the time:

“The IXYS extensive power semiconductor portfolio and technology expertise aligns with the key objective to accelerate our growth across power control. It diversifies and expands our presence within industrial and electronics markets, with a tremendous OEM customer base. We also expect long term increased content per vehicle by expanding our combined power semiconductor portfolio with automotive customers. These were all areas we identified as significant elements of our 5-year strategy. The combination is highly complementary in many areas, including technology capabilities, product portfolio, end markets and sales channels. The combination will also bring many more opportunities for our collective employees and new differentiated solutions for our customers. We look forward to welcoming the IXYS team to Littelfuse.”

Overall, Littelfuse’s capital allocation practice has been efficient, evidenced by its growth in free cash flow (“FCF”) per share. In 2014, Littelfuse generated $5.37 per share in free cash flow. By 2023, that figure grew to $14.90, which represents a CAGR of 15.0% over the 10-year period. This has come with Littelfuse consistently keeping its net debt to EBITDA ratio, a popular debt evaluation metric, close to 0.6 over the last decade. Most shareholders would be happy to see their management deploy most of the FCF toward acquisitions if it means the FCF per share continues to grow at a solid clip. In fact, the FCF per share has outgrown the Littelfuse stock over the last 10-years too, which has a CAGR of about 12%. That FCF per share CAGR also outpaced Eaton which saw FCF per share grow at a CAGR rate of 11.8% in the past decade.

Management and Incentives: Littelfuse has been led by David Heinzmann as CEO since January 2017. Heinzmann joined the company as an engineer in 1985 and worked his way in increasing roles, including VP of the automotive segment from 2004 to 2007, VP of global operations from 2007 to 2014 and COO from 2014 until taking over as CEO in 2017. Heinzmann took over for Gordon Hunter who was CEO for 12 years and before that Howard Witt was CEO for 15 years so there’s been good stability for the past 30+ years.

Meenal Sethna joined Littelfuse as SVP, finance in May 2015 and was promoted to CFO in March 2016. Before Littelfuse, Sethna held corporate finance roles at Motorola and Baxter International.

The third highest ranking executive is Ryan Stafford, who wears a few hats with the title of EVP of M&A, chief legal officer and corporate secretary. Stafford joined Littelfuse as general counsel and VP of human resources in 2007. His background is both in operations and legal having previously served as VP of China operations at Tyco International.

Littelfuse’s executive compensation program consists of a base salary, annual bonus tied to financial metrics and stock-based compensation, called long-term incentive compensation. Management is also sporadically given discretionary “wellness” bonuses. CFO Sethna has been a frequent recipient of the wellness bonus, while Deepak Nayar, general manager of the Electronics Business, has been given bonuses related to the patent program.

To understand how management is incentivized, let’s start with the annual bonus. Named executives are paid annual bonuses with the target amount ranging from 60% to 120% of their base salary. The incentive is a blend of corporate sales, EPS, cash from operations, individual performance and business segment performance for Nayar, who heads the Electronics segment. See the graphic below for the weighting for each executive’s annual bonus composition. The targets were sufficiently difficult so that only the cash flow metric generated a payout in 2023. However, management had bonus payouts near the max in the prior two years.

The largest component to executive compensation at Littelfuse is the long-term incentive, known broadly as stock-based compensation. CEO Heinzmann had 69% of his compensation paid out through stock and the rest of the executives were at 57% in 2023 (both higher than recent years). The accounting value of the stock-based compensation is split evenly between restricted stock units (“RSUs”) and stock options. RSUs vest in thirds over a three-year period regardless of performance while stock options also vest over a three-year period at Littelfuse. The RSUs and stock options are both structured in relatively simple methods and the latter directly incentivizes management to grow the stock price above the strike price (market price upon grant date). I have no issue with a company employing simple incentive metrics. Given the reliance on M&A, I can imagine some investors would prefer stock-based compensation to be more closely tied to M&A efficiency. However, applying M&A incentives tends to be messy and I think the pros don’t actually outweigh the cons. As it stands, Littelfuse management needs to win over the market in order for the stock options to truly grow in value and that’s the most important attribute.

Outlook: Littelfuse last issued earnings on April 30, and at the time, management guided Q2’24 revenue growth to be down -11.8% YoY and up 0.9% compared to Q1’24. Management does not give full-year guidance, but they did disclose 2024 assumptions that included a return to sales growth. This implies a recovery from the trough for this cycle will be slow and modest.

Cycles for Littelfuse are normal, with business ebbing every three or four years, at least to a modest level. In the past, growth generally stalls out with a four to five quarter peak-to-trough length,, so the current 2023/2024 trend has been longer than usual. David Heinzmann pinned the reasoning on the unusual nature of the post-COVID supply chains during the May 1 earnings call:

“And we've talked about how in the electronics side of our business that, it's been a bit of a long-gated cycle. So it's the peak to trough has been a little longer than we have typically seen before, and we really think that based on our analysis and the work we do with customers is that is really driven out of the fact that end customers, EMS, OEMs, bulked up a little more on inventory in this past cycle than historically, they have because of all the disruptions that were taking place. So that's what's kind of elongated.”

I think the light at the end of the tunnel is near for this present cycle for Littelfuse. Given CEO Heinzmann recently said inventory de-stocking is nearly complete, with only another quarter or two of drag left, and revenue appearing to stabilize, it’s likely Littelfuse can return to modest organic growth in 2025.

Zooming out, Littelfuse’s longer-term growth themes of electrification and electronification are in tact. During my research of Encore Wire I discussed ‘electrification of everything’. Just as it sounds, we’re talking about electrifying everything. Infrastructure that was previously fossil fuels getting switched to electric, and other consumer products getting switched to electric. Think stoves and furnaces. In Washington State, where I live, we’re also electrifying ferry boats - WSJ article looking at electrifying public transportation. Littelfuse benefits from a grid that’s getting electrified because the increase in electricity means there’s an increase in moving it safely and therefore a need for fuses. Littelfuse’s adjacent product category of power semiconductor’s also benefits because they help start and stop the movement of electricity.

The other theme Littelfuse emphasizes is electronification, which refers to the growing number of electronic components in various products. Over the decades, the volume and complexity of electronic components have increased significantly. For instance, while every car now has electronic windows, it’s becoming more common to see advanced connectivity features in vehicles. This includes sensors that assist with parking and collision avoidance, as well as systems that allow drivers to adjust suspension settings between sport mode and eco mode. Littelfuse plays a crucial role in this trend with its wide range of sensors and power semiconductors. Their offerings include speed sensors, fluid level sensors, and position sensors, which are essential for powertrain, chassis, and comfort and convenience applications. Specifically, their sensors support active suspension systems by providing real-time data that helps in adjusting the suspension for optimal ride comfort and handling.

The industry tailwinds should support modest organic growth. However, the other notable growth driver for Littelfuse’s outlook is the M&A spend. The company hasn’t entered into a material acquisition since June 2023, and this follows a modest year of acquisition spend in 2023 overall. Littelfuse has ample capacity to take on additional debt to fund deals right now. Their own method of calculating net debt/EBITDA sits 1.4X, which is below their target of 2.0X meaning they could $300M in debt to fund an acquisition. I’ll note that their method of calculating is conservative by only including cash held in the U.S.

I’ll note a few risks to the near and medium-term outlook. The first is that a return to growth takes several more quarters, which is already past a normal cycle length for Littelfuse. Growth hasn’t shown signs of a turnaround yet and so investors will be cautious watching to see that growth does materialize in the coming months.

Another potential headwind to watch for is the recall that Littelfuse disclosed in the May 2024 10-Q. Littelfuse added a risk factor stating a customer notified them of “a product recall potentially due to certain fuses provided by the Company”. It’s unclear at this point if the recall will be material financially. However, it was a rare move for Littelfuse to add a risk factor in a 10-Q as it’s been four years since the last time a risk factor was added in a 10-Q, according to inFilings data. Littelfuse discloses and updates risk factors annually in 10-Ks instead of 10-Qs. Even if the recall doesn’t cause a financial headwind, there’s a potential harm to their reputation. Given Littelfuse's role in supplying mission-critical components, long product life cycles, and high switching costs, reputation is important. When a manufacturer builds with Littelfuse components they’re often doing so for a product’s life that could be five to 10 years. Reliability is paramount and maintaining an impeccable reputation is crucial. Swiftly and effectively managing this recall will be key to reassuring risk-averse OEM customers of Littelfuse's commitment to quality and reliability, preserving their trust and continued business. This response will help mitigate the risk of customer attrition and reinforce Littelfuse's long-standing industry position.

Lastly, another risk for Littelfuse lies in its strategy of relying on acquisitions to drive growth, aiming for about 6% annual growth through M&A as stated by management. There's a potential for overpaying for targets due to their commitment of growth via acquisitions. However, I trust the management team, which has a strong history of handling cash effectively for opportunistic buybacks and making acquisitions that have enhanced shareholder value and improved free cash flow.

Valuation: To value Littelfuse, I built a discounted cash flow model for the next five years through 2028. My forecast indicates the Electronics segment continues to drag company-wide revenue in 2024 then rebounds in 2025 with growth moderating after the cyclical weakness in 2023/2024. Transportation will have modest growth throughout the period, in-line with the organic growth history. My expectation also indicates a poor year for the industrial segment, which is an extension of material negative growth in Q1’24. However, this segment has been the strongest in the last decade and next five years should also be strong backed by growth in renewable energy.

The approach to fold in the M&A impact is simple. The assumption is that Littelfuse continues to acquire businesses at 2.0X a price-to-sales ratio. In 2024, there’s M&A spending of $50M model, then $200M in 2025 and then increasing by $50M each year through 2028. Therefore, half of those amounts are added each year through additional acquired revenue. The 2.0X ratio was decided based on the valuation multiple paid over the last three years. Including the acquired revenue via M&A spend, the CAGR total revenue increase from 2023 to 2028 is a modest 7.2%.

Littelfuse has an average EBITDA margin of ~21% over the last decade. It was 24.7% in 2022, then regressed to 21.1% in 2023. My forecast includes a continued increase in the EBITDA margin before gradually reaching a mid-cycle level of 24.0% in 2028. The EBITDA is expected to increase at a CAGR of 10% during the model.

The cost of capital of 9.0% is calculated primarily through a beta of 1.32 and an equity risk premium of 4.6%. Littelfuse has traded with an average 14.0X EV/EBITDA ratio (trailing 12-months) over the last 10-years which is selected for the exit multiple of the DCF model. Altogether, the calculated fair value is $313.00, or about 26% higher than the current stock price.

The financial outlook in the model is fairly conservative for a company that grew revenue and operating profit ~12% annual over the past decade. Many investors approach M&A expectations and valuations differently, so that’s certainly a wild card in this model. If you subtract it out of free cash flow differently than I do, your intrinsic valuation calculation could look materially different than my valuation of $313. For a more simple valuation marker I’ll add that Littelfuse is currently trading ahead of their average forward EV/EBITDA ratio of 13.2X with a current multiple of 14.4X. This is also slightly higher than their competitors, who have a median of ~12X. Taken together, the relative valuation approach indicates Littelfuse is at fair value. My preference for valuation is to lean on the DCF model.

Conclusion: Littelfuse isn’t the most exciting company, but they are a quality company with a rich history and I believe good they have a good runway ahead of them. Their secular tailwinds of electrification and electronification provide plenty of organic growth in the coming years and the electronic parts industry could consolidate further, providing plenty of M&A opportunities.

After researching Littelfuse I was left thinking, can this company become the next Eaton? or at least a mini Eaton. I pointed out in the competition section that Littelfuse needs to lean into higher growth markets, such as data centers due to the elevated demand from AI. Management also needs sell the idea that they’ll benefit from high-growth end markets. If they can do that, ideally shares could grow based on the multiple expansion. Eaton trades at a rich 23X forward EV/EBITDA, which has steadily grown over the last decade alongside the rise in their profit margins. However, Littelfuse trails that mark quite a bit at 14.4X.

As a long-term investor, I’m less concerned about perfectly timing the cycle turning and growth returning for Littelfuse. I’d be an interested buyer of Littelfuse at about $230.00 per share, which would imply 35% upside at that point, and enough margin of safety. It’s also the valuation at which Littelfuse decided to buy back its own shares in Q1’24.

On a personal note, it’s been nearly three months since I last published a deep dive, which is a longer stretch than usual. My wife and I welcomed our second baby in April so my hands have been full during my usual blogging time. I hope to get back to my regular cadence in the coming months so look out for more research updates this summer.

Disclaimer: The content of this report is for informational and research purposes only and should not be construed as financial advice. The views expressed are my own and do not reflect those of my employer. While care has been taken in preparing this report, I make no representations or warranties of any kind regarding its accuracy or completeness. I currently hold no position in any stock mentioned. However, like any financial analyst, my perspectives may carry inherent biases. Readers are encouraged to conduct their own due diligence.

By leveraging the services of SPS, companies are empowered to enhance their supply chain performance, fine-tune inventory levels for better sell-through rates, cut operational costs, and improve the visibility of orders. Moreover, SPS' solutions play a crucial role in helping businesses meet the consumer's growing expectation for a seamless omnichannel shopping experience, which has become a cornerstone of modern retail.

As the retail sector continues to evolve, driven by shifts towards ecommerce and heightened consumer expectations for flexibility and speed, the demand for integrated, omnichannel supply chain solutions is heightened. SPS' cloud-based retail network acts as a nucleus in the retail landscape, offering a unified platform where businesses can manage transactions across all channels efficiently. This not only streamlines operations but also significantly reduces the likelihood of errors, fostering a more cohesive and responsive supply chain ecosystem.

The themes of a shifting retail sector and a meaningful network effect are positive attributes of the investment rationale in SPS. SPS has a history of good execution and consistent strong financial results, driven by its community success. The risk/reward is well-balanced, with a strong network helping fend off threats and drive future growth. The valuation calculations imply modest upside of 26% upside to the current stock price.

The rest of this analysis will cover SPS by providing an overview of the business and the competitive edge followed by an examination of the capital allocation history, management and their incentives, capped with an outlook and valuation.

Business Overview: SPS offers a suite of products designed to modernize the way businesses across the retail spectrum—from grocers to logistics firms—manage their operations and trading relationships. The company's solutions aim to replace outdated manual processes and fragmented systems (such as email, phone and fax) with a unified approach through its extensive retail network. This is the concept of an electronic data interchange (“EDI”).

At its core, EDI is the computer-to-computer exchange of business documents in standardized electronic formats between trading partners. This technology enables businesses to automate the transaction process, resulting in significant benefits like reduced operational costs, faster processing times, minimized errors, and strengthened partner relationships. Unlike processes that rely on human intervention, such as email, EDI allows direct interaction between the partners' IT systems, enabling documents like purchase orders, invoices, and shipping notices to be processed instantly and without manual input. This automation ensures that data flows seamlessly from one system to another, facilitating a more efficient, accurate, and cost-effective supply chain operation. It’s like having a universal translator between business, and this is especially useful when one retailer has multiple suppliers and vice versa.

SPS doesn’t report separate business segments, but they do categorize their product lineup into three main areas:

• Fulfillment (80.8% of revenue): This cornerstone product provides a scalable EDI solution that allows companies to manage orders across channels. Tailored for flexibility, Fulfillment can be configured to match any trading partner's requirements, facilitating seamless supply chain management with a comprehensive set of tools.

• Analytics (10.4% of revenue): Aimed at enhancing product sales visibility, the Analytics product offers organizations a unified view across all sales channels. It leverages SPS Commerce's extensive network and expertise to grant better access to and utilization of sales and inventory data, helping businesses to make informed decisions and optimize performance.

• Other Products (1.8% of revenue): Under this category, SPS provides additional solutions like Assortment, which simplifies the management and communication of item data across various sales channels, and Community, designed to digitize supply chain processes and bolster supplier collaboration through effective onboarding programs.

These offerings, complemented by one-time services like professional services and testing and certification, underscore SPS’ commitment to facilitating more efficient and integrated supply chain and omnichannel retail operations worldwide.

SPS Commerce harnesses the power of its extensive cloud-based retail network to foster connections between various players in the supply chain, including retailers, grocers, distributors, suppliers, and logistics firms. This network acts as a catalyst for new customer acquisitions, leveraging the "network effect" as a foundational pillar of its growth strategy. The concept is simple yet profound: the value of SPS' network multiplies with each additional connection, making it easier for existing and new customers to find and collaborate with trading partners already on the platform. This interconnectivity not only facilitates seamless information exchange but also encourages incremental sales opportunities and revenue streams for all network participants.

The expansion of SPS' network is driven by various customer acquisition sources. The company's Community product plays a crucial role in adapting trading relationships to the evolving demands of an omnichannel retail environment, generating supplier leads in the process. Additionally, referrals from within the existing customer base introduce new participants to the network, further enriching its diversity and utility. SPS also engages in direct marketing efforts, ranging from digital campaigns to industry events, aimed at capturing the attention of key decision-makers. Moreover, collaborations with channel partners, including major ERP software providers and logistics companies, extend the reach of SPS' products, embedding them into broader service offerings and driving new sales. Through these multifaceted strategies, SPS Commerce continually strengthens and expands its network, underscoring the company's commitment to enhancing the efficiency and connectivity of the retail supply chain.

To illustrate SPS Commerce's go-to-market strategy more concretely, let's explore a practical example. Imagine SPS gets a lead from an ERP vendor that Dick's Sporting Goods (DKS) is transitioning to a new ERP system (change event). This period is an opportune moment for SPS to introduce their EDI solutions, facilitating a seamless switch for the retailer from their existing EDI provider. SPS' strategy involves a collaborative effort to onboard all of Dick's suppliers, including companies like Ping and Callaway, each likely using distinct formats for invoices, purchase orders and other documents. By standardizing these communications through their EDI system, SPS streamlines the data exchange, enhancing supply chain visibility for Dick's and enabling suppliers to better manage their inventory, thanks to precise insights into product movements.

The strategy of SPS' monetization model primarily targets the suppliers by charging them based on their number of connections within the network, rather than the retailers. This approach not only ensures a more extensive digital network but also encourages suppliers like Ping to advocate for SPS' EDI system with their other retail partners, thereby amplifying the network effect. As these relationships grow, so does the ecosystem of interconnected partners, creating a cascading effect of increased efficiency, enhanced data accuracy, and more informed decision-making across the entire supply chain. Note that I don’t know if Dicks is a customer of SPS, but I do know Ping is a customer, according to a case study on SPS’ website. I like this example because I bought a Ping putter last month and you’d be shocked just how many options there are for a putter, not just head but shaft style too. And I can imagine how much Ping can benefit as a supplier knowing what inventory is at their retailers.

SPS Commerce is strategically positioning itself to capture a significant portion of the global retail network and supply chain management market, with an eye on a total addressable market (TAM) of $5.0 billion, a figure SPS has stated for four years now. Given that TAM has likely grown, SPS has low penetration when compared to 2023 revenue of $536.9 million. The company's growth strategy is multifaceted, aimed at cementing its status as the leading provider in this space. A critical aspect of this strategy involves deeper penetration into the current market, which SPS views as underexploited. With the retail industry continuously adapting to the omnichannel marketplace's demands and the supply chain ecosystem growing in complexity, SPS anticipates an uptick in demand for its solutions. The company plans to leverage existing customer relationships and their networks to generate new sales leads, aiming to increase revenue from its current customer base by encouraging the adoption of additional products and services.

Innovation and acquisition are also components of SPS' growth agenda. The company is committed to refining and expanding the capabilities of its cloud-based products, occasionally introducing new offerings to meet evolving market needs. Strategic acquisitions are part of its growth strategy with an emphasis on selective integration that broadens customer reach, enhances product functionality, or extends geographic presence.

SPS identifies a substantial market opportunity in assisting organizations to expedite their omnichannel retail strategies. The need for new connections and transactions is growing as businesses expand across wholesale, eCommerce, and marketplaces, making SPS' retail network an integral part of their omnichannel approach. Furthermore, the retail sector's push for automation—driven by fluctuating store openings and closings, labor shortages, and shifting buying patterns—underscores the necessity for agile and efficient supply chain solutions. SPS' offerings enable businesses to swiftly adapt to market changes and maintain a competitive edge through enhanced visibility and automation.

Moreover, the consumer demand for new and differentiated products adds another layer to the market opportunity. Retailers are constantly refreshing their assortments to keep pace with trends and consumer preferences, necessitating robust trading partner relationships that can support quick product introductions. SPS' network facilitates these dynamics, ensuring smooth operations and enabling retailers to achieve their merchandising objectives.

Building on the foundation of meeting consumer demands and supporting dynamic retail assortments, SPS Commerce further solidifies its market position through its advanced technology, development, and operations framework. Embracing cloud services since 1997, SPS has positioned itself as a pioneer in cloud-based solutions for the retail supply chain management industry. At the heart of its technological infrastructure is a multi-tenant cloud-service model. This approach allows SPS to treat all customers as separate entities within a shared environment, enhancing scalability and cost-efficiency by distributing operational expenses across its broad customer base. Unlike single-tenant solutions, where each customer requires a separate instance of the software, SPS' multi-tenant architecture enables rapid scaling and streamlines updates, without the need to manage numerous distinct applications.

The company's commitment to innovation is evident in its research and development efforts, primarily conducted across strategic global locations. By focusing on multi-tenant products, SPS maintains lower research and development costs and introduces software updates more frequently than is typical with traditional on-premise software. Operations are managed through third-party data centers and cloud providers, ensuring high availability, redundancy, and continuous performance monitoring. This operational excellence, coupled with a dedicated global sales force and a comprehensive marketing strategy, underpins SPS Commerce's ability to deliver customer success and retention. Through this integrated approach, SPS not only enhances its service offerings but also ensures that it remains at the forefront of facilitating efficient, robust trading partner relationships in the ever-evolving retail landscape.

Financial Performance: SPS began trading in 2010 and it generated $44.6M in revenue that year. That figure has increased to $536.9M in 2023 for a compounded annual growth rate (“CAGR”) of 21.1% per year. While that growth rate is impressive, SPS’ relatively steady annual growth has also been impressive. SPS has had positive quarterly growth year-over-year (“YoY”) for 92 straight quarters (23 straight years dating back to 2000). Koyfin has quarterly data going back to Q4’09 and since then the lowest YoY growth rate was 10.3% and the median is 20.1%.

SPS has also exhibited a trend of increasing profitability over the past 20 years. In 2006, EBITDA margins were about 3%. During the past four years (2020 to 2023), EBITDA margins have been tightly focused near 21.0%.

When you common size the different costs on the income statement against revenue, you can quickly see the improvement in margins has been garnered through a steady drop in sales & marketing expenses. In 2013 sales & marketing expenses made up 38.0% of revenue and by 2023 that number dropped to 22.9%. Research & Development as a percent of revenue, and general & administrated costs as a percent of revenue stayed steady over the last decade. Gross margins dipped slightly due to the rise of cost of revenue (“COGS”) which made up 30.4% of sales in 2013 and now makes up 33.9% of revenue. The steady drop in sales & marketing spend, relative to sales, shows efficiency considering growth hasn’t slowed significantly over the past decade.

Two other relevant KPIs for SPS is the number of recurring revenue customers and recurring revenue per customer, which SPS calls wallet share. Here’s the quote of their definition.

Wallet Share - We calculate average recurring revenues per recurring revenue customer, which we also refer to as wallet share, by dividing the recurring revenues from recurring revenue customers for the period by the average of the beginning and ending number of recurring revenue customers for the period.

I extracted data for wallet share and recurring revenue customers back through 2013. Wallet share in 2013 was $4,920 which increased at a CAGR of 8.9% to $11,550 in 2023. The number of recurring revenue customers similarly increased at an annual rate of 8.6% from 19,690 customers in 2013 to 44,800 in 2023. It’s nice to see both the number of customers and average revenue per customers increasing at similar rates over the past decade, implying SPS isn’t simply increasing the price or adding customers. It’s able to do both.

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Competition: In the landscape of supply chain management (SCM), companies navigate through a complex matrix of offerings, from traditional on-premise solutions to innovative cloud-based services. Among these, SPS Commerce emerges as a distinctive player with its full-service model, contrasting sharply with its three named competitors from the 10-K: IBM , OpenText , and privately-held TrueCommerce. Understanding these entities and their competitive dynamics sheds light on how SPS Commerce has carved its niche in the industry.

IBM, a behemoth in the technology sector, offers a range of Supply Chain Management (“SCM”) solutions, including its Sterling suite. Focused on traditional on-premise software as well as managed services, IBM Sterling caters to businesses seeking robust, customizable solutions that they can control and manage internally. This "do-it-yourself" approach requires significant investment in both hardware and skilled personnel to maintain the systems, offering a single-tenant architecture that ensures dedicated resources and customization for each client. However, this model often involves higher upfront costs and complexity, potentially limiting its appeal to larger organizations with the necessary resources.

OpenText specializes in information management software, including supply chain management solutions. Similar to IBM, it offers both on-premise and cloud-based managed services, focusing on businesses that prefer to manage their supply chain integration with a blend of internal and external resources. OpenText's acquisition strategy has expanded its portfolio but also indicates a reliance on acquisitions for growth. This approach, while expanding its capabilities, may dilute its focus on organic innovation within the supply chain segment.

TrueCommerce positions itself as a provider of managed service solutions in the supply chain space, offering cloud-based products that combine technology development and maintenance with customer-led daily operations. This model aims to strike a balance between fully managed and self-managed solutions, offering a degree of customization and operational control without the full burden of on-premise software management. TrueCommerce, through this hybrid approach, competes by offering scalability and flexibility, appealing to a wide range of businesses seeking to streamline their supply chain operations.

SPS Commerce is notably different than its peers by primarily focusing on its full-service cloud-based model. Unlike its competitors, SPS Commerce delivers a comprehensive solution that encompasses not just the technology but also the resources to customize, optimize, and operate it. This approach significantly offloads the burden of managing SCM products from businesses, allowing them to focus on their core competencies rather than the intricacies of supply chain management.

When I looked up online reviews for the different EDI providers, I often didn’t see SPS at the top. For instance, software review aggregator G2 lists TrueCommerce as number one followed by SPS and then IBM’s Sterling. From what I gathered users tend to favor SPS’ ease of use and UI, but dislike the tack-on fees and aggressive sales tactics. A good research tactic is reading what other competitors also say about the subject company. So in this case I found the OpenText blog post titled “Time to take a closer look at SPS Commerce reviews” enlightening. OpenText acknowledges SPS is often the “early bird” in talking to potential customers first and rushing them along to close a sale. Recall the go-to-market strategy begins with a software change event, then as soon as a retailer joins SPS, they make it a mission to on-board all of the suppliers of said retailer. It’s a successful playbook for SPS that’s underscored by its impressive financial performance and stock growth.

The competition section of the 10-K highlights key factors that differentiate cloud-service vendors: the breadth of network connections, reliability, reputation, price, market specialization, integration speed and quality, product functionality, complementary product offerings, and customer support. SPS Commerce's positioning as a full-service provider leverages these factors to its advantage, offering a compelling value proposition that has enabled it to outperform peers like OpenText and IBM in both financial growth and stock performance.

SPS Commerce's model of providing a fully managed, cloud-based service has resonated with businesses looking for scalable, efficient, and cost-effective supply chain solutions. The message has been delivered to clients as well. Former CEO Archie Black discussed this by saying SPS has a successful go-to-market strategy whereas its competitors don’t. This has not only allowed SPS Commerce to grow organically at an impressive rate but also to distinguish itself from competitors who either focus on traditional on-premise solutions or a mix of managed services that require more involvement from the customer's internal team.

Capital Allocation: In order to analyze capital allocation, I’m going to compare SPS against Open Text. Over the last 10-years (2014 to 2023), SPS generated $641.7M in cash from operations. They spent $134.7M back into the company via capital expenditures, equal to 21.0% of the cash from operations. $347.3M was spent on acquisitions (54.1% of cash from operations) and another $128.9M was spent on buybacks (20.1% of cash from operations). There’s been no dividend payouts. Given that the four buckets of capital allocation (CapEx, M&A, buybacks and dividends) is less than the cash generated, it means SPS has been building its cash position. SPS has an immaterial amount debt and has been operating the business with a net cash position.

The strategy for buybacks has been to opportunistically return cash to shareholders during periods of weakness. SPS has frequently been in the market for its shares since 2018 and it’s notable that they’ve accelerated into weakness multiple times, a good indication that management applies a valuation-based approach to capital allocation. The strategy around M&A has been fairly tactical with modest acquisitions. The largest acquisition was Data Masons, a provider of EDI System Automation solutions for the Microsoft Dynamics market, in December 2020 for $100.0M. Data Masons was a competitor to SPS and added modestly to the customer count. Management at the time said the acquisition expands SPS' position in fulfillment system automation for Microsoft ERP customers. CEO Archie Black said:

“The primary rationale of this deal is that combined, we think we can sell more, and we think we can have a better customer service [experience]. So that's really the rationale of the deal. So in the non-Microsoft space, it's business as usual in the Microsoft part of our business, it will be an acceleration. So we really don't -- this is not a cost synergy play. This is really a growth plus customer experience story.”

In 2022, SPS spent $45.1M to buy GCommerce, an EDI provider in the automotive industry. The acquisition of InterTrade that same year for $49.1M pushed M&A spend near $100M in 2022 again. InterTrade’s EDI solution was focused in the apparel and general merchandising markets. The last material transaction worth noting was TIE Kinetix in September 2023 for $68.7M. TIE Kinetix was a provider of supply chain digitalization e-invoicing in Europe and the United States. The business was 60/40 Europe/US. Where they excelled was e-invoicing for tax purposes that’s mandatory in Europe. Overall all these were bolt-on in nature.

As for OpenText, the company spent $791.M on capital expenditures (11.2% of cash from operations), $1.6B on dividends (22.5% of cash from operations), $629.1M on buybacks (8.9% of cash from operations). The standout metric is the $12.5B spent on acquisitions (176% of cash from operations). By spending near 2X the cash it’s generated from operating the business, OpenText has been tapping the debt market and currently has ~5X net debt/EBITDA.

Almost half of the total M&A spend during the last 10-years at OpenText was on enterprise software company Micro Focus in 2023 for $6.2B, when including debt. That deal was priced at a significant, 99% premium to the market price of Micro Focus at the time. Via Forbes, Moody’s said at the time:

“Both companies generate a large share of their revenues from declining and mature products and the challenges are compounded by the highly competitive software segments they operate in that are increasingly adopting cloud software solutions.”

There’s two other acquisitions greater than $1.0B in the past decade for OpenText. In December 2019 they spent $1.4B on Carbonite, a provider of backup, disaster recovery and endpoint security to small and medium-sized consumers. OpenText also did a big acquisition in January 2017 when it spent $1.6B for the enterprise content division of EMC Corporation. OpenText CFO Madhu Ranganathan told Forbes in an interview:

“We have done over 80 acquisitions. We have doubled the size of the company between 2019 and 2022. We look at timing, the quality of the assets, the opportunity for value creation, and return on investment. We try to integrate the acquired company before the deal closes.”

The series of major acquisitions, and only modest buybacks, has come with OpenText shares outstanding increasing by 10.6% since 2014. By comparison, SPS’ shares outstanding increased by 13.1% over the same period. However, free cash flow has increased more rapidly. In 2014 SPS had free cash flow per share of 17 cents that increased to $3.04 by 2023, representing a 22.8% CAGR. OpenText had FCF per share CAGR of just 6.8% in the last 10 years. This largely explains the difference in stock performance with SPS shares doing 18.9% CAGR and OpenText doing just 6.0%.

Before wrapping up the capital allocation portion, I wanted to compare organic reinvestment a bit more. Particularly because SPS invested notably more on CapEx, on a relative basis, and less R&D than OpenText. SPS Commerce reinvested 21% of its cash from operations towards CapEx, about half of which was invested in internally developed software according to the balance sheet footnotes. This strategy not only emphasizes their commitment to enhancing and expanding their technological capabilities but also indicates a preference for capitalizing costs associated with software development. This showcases a judicious investment strategy by sensibility investing internally, aligning with accounting practices that favor capitalization when the resulting assets are expected to generate predictable, long-term value. This methodical approach to reinvestment has been mirrored in SPS' strong financial performance, underscoring a prudent yet effective deployment of capital that supports sustainable growth and bolsters investor confidence.

On the other hand, OpenText's allocation strategy—marked by a lower percentage of cash flow directed to CapEx and an aggressive 18% of revenue funneled into R&D—paints a picture of a company heavily invested in fostering innovation and expanding its technological frontiers. This aggressive R&D investment, while indicative of a forward-looking stance, also reflects a high-risk, high-reward philosophy that has not translated into proportional financial performance or stock appreciation as effectively as SPS. The stark contrast in their financial trajectories suggests that OpenText's expansive R&D expenditure, though potentially positioning the company at the forefront of technological innovation, may not be yielding immediate financial returns in the same way SPS' more conservative and focused reinvestment strategy has.

Management and Incentives: SPS was founded in 1987 and was called St. Paul Software, of course, based in St. Paul, Minnesota. Archie Black joined the company in 1998 as CFO during the tech boom. St. Paul Software operated like other technology companies in that era by regularly burning cash. By 2000, St. Paul Software focused the business by leaning into the EDI and selling their software business to Tie Commerce. Black was elevated to CEO in 2001 and St. Paul Software renamed itself to SPS Commerce that year. Black continued to lead SPS, alongside COO Jim Frome, until retiring in October 2023. In July 2023, SPS disclosed that Frome will retire at the end of 2024, and on February 29, 2024 SPS added that Black will step down as chairman and depart the board on December 31, 2024.

Black has been succeeded by Chad Collins, who was most recently served as CEO of Software for Korber Supply Chain within Germany’s Korber Group. After starting his career at Ernst & Young, Collins joined Minnesota-based HighJump Software in 2002. HighJump was acquired by Accellos in July 2014, backed by its PE owner Accel-KKR. Accellos was then reorganized as HighJump Software, which provided supply chain execution software, and TrueCommerce, which is SPS’ closest overall peer. Collins became CEO of the HighJump business and Accel-KKR then separated it from TrueCommerce in 2017 when it sold HighJump to Korber for ~$750M, and Collins went with it. As an aside, Accel-KKR more recently sold TrueCommerce to PE firm Welsh, Carson, Anderson & Stowe (“WCAS”) in December 2020. Collins is a fitting hire for SPS because of his deep supply chain software experience and he’s local to Minneapolis. Not only will be sufficiently knowledgeable as a leader I expect he’ll fit in culture-wise. SPS has generated about 85% of sales from the U.S. in the past five years. Ideally Collins can apply his global experience from Korber to help drive SPS sales outside of the U.S.

Despite the succession at the top ranks of SPS, the CFO role has held steady with Kim Nelson holding that title since 2007. Nelson joined SPS from Amazon where she led investor relations from 2005 to 2007. From what I can tell Nelson is a solid CFO and after 16 years with SPS, it’s nice seeing her stay during the CEO succession.

SPS Commerce’s executive compensation program is split between salary, an annual cash bonus, stock awards paid in the form of restricted stock units (“RSUs”) and performance stock units (“PSUs”). The following analysis uses the March 2023 proxy and I’m going to generalize by incorporating incentives for Black and Frome. Note that SPS filed an employment agreement for Collins when they hired him and disclosed that his pay and incentives match the existing executive compensation elements. The only difference was that Collins will actually be paid more than Black, which is mildly unusual as new executives generally have to work their way up to a tenured executive’s pay like Black.

During the six year period from 2017 to 2022, former CEO Black was paid about 10% of his total compensation in salary while Nelson and Frome were slightly above that at 13%. The annual cash bonus made up 11% and 13% for Black and Nelson/Frome, respectively, while stock-based compensation made up 79% for Black and 73% for Nelson/Frome. Other compensation, which was just 401K contributions, was negligible. The value of the total compensation is slightly low for SPS when comparing to some proxy peers such as of similar size such as Varonis Systems (VRNS) and Paylocity (PCTY).

The two incentives for the annual cash bonus is revenue and adjusted EBITDA. The target value of the cash bonus was 100% of Black’s and Frome’s salary, and equal to 75% of Nelson’s salary. Payouts could range from 0% to 195% (up slightly from the 190% cap in 2021). For 2022, SPS set a revenue target of $454.6M, which compares to their initial full year 2022 guidance of $444M given in February 2022. The adjusted EBITDA target for compensation was $128.4M and that compares to guidance of $125.8M. It’s nice to see the compensation committee set higher financial targets for 100% payout than the guidance delivered.

The last and largest component of executive compensation is paid in the form of stock awards. In 2019, 46% of the grant date fair value (“GDFD”) of equity awards was paid in the form of RSUs, 31% in PSUs and 23% in options. SPS moved away from options beginning in 2020 and inched toward a 50/50 split with half the stock pay in the form of RSUs and half from PSUs. While the weighting has changed during that period, what’s been consistent is that the incentive for PSUs is relative total shareholder return (“TSR”). In order for management to earn 100% of the PSUs awarded to them, SPSC shares have to beat their stated index, the Russell 2000, by at least 5% over a three-year period. Relative outperformance of at least 30% means the PSUs get paid out at a maximum of 200%.

This is a simple and effective way to set up executive compensation and I applaud SPS. In total, roughly 35% of executive compensation is tied to total shareholder return, keeping management focused on the main metric shareholders look after. This focus on relative total shareholder return is similar to Apple (AAPL).

Outlook: SPS just wrapped up 2023 by growing 19% YoY. The February 8 earnings call also included full year 2024 revenue guidance of $617.8M, which represents growth of 15% over 2023. SPS management is expecting some operating leverage because guidance for adjusted EBITDA to increase 16.5% YoY, slightly higher than the revenue growth. Adjusted EBITDA is expected to be $184M in 2024 for a margin of 29.8%.

SPS is among the companies that gives a medium-term guidance. Beginning July 2021, management began stating their medium-term goal for growth in recurring revenue is 15% annually, up from their prior goal of 10% annual growth. At that time it was driven by an acceleration in e-commerce and a digital transformation to an omnichannel experience. CFO Nelson reiterated that goal in the February 2024 earnings call. Then more recently, in the March 7 Morgan Stanley TMT conference, Nelson expanded by discussing the four reasons SPS has confidence they can grow at 15% or greater. 1) community success of increasing customer counts by onboarding suppliers of retailers, 2) customer growth leading to higher wallet share, 3) cross-sell opportunities with different products and 4) tuck-in M&A. For greater context here’s the direct quote by Nelson.

“the reason we have such strong conviction and that is because there's multiple levers or multiple ways in which we have demonstrated our growth. And those same ways we believe are still there going forward. When we think about what drives that top line growth, that community go to market that Chad and I have both spoken about, we still see a lot of opportunity there, and that drives us to get more and more on net new customers.

And then over time, those customers grow with us. So there's multiple ways in which that translates into additional revenue for us and size of customers, our channel sales, bringing us to those larger customers. That is an important portion of our business and that will remain going forward. We really see that as a great lead generation as well. Over time, we see the opportunity to not just upsell but also cross-sell with different products. Our two primary products we have today, our fulfillment product and our analytics product. But over time, we see the opportunity to even have more products that can benefit our customers.

So all of those would be reasons that would give us conviction on that top line. And then M&A, we've talked about M&A now. They typically have been more tuck-in type acquisitions really because it's quite and are fragmented in this space. But that certainly we see the opportunity for us. That's a great way to end customers. So roll-up strategy as well as product enhancement, technology enhancement or geographic expansion. And we've done all of those types of acquisitions.”

I view this medium-term goal post as quite attainable for SPS. The company has shown its go-to-market strategy and network effect in particular has been successful in the past. Moreover, SPS’ total addressable market leaves a long runway for growth. Recall the total addressable market is $5.0B, but SPS has stated that TAM for several years now. In a November 2021 Credit Suisse TMT conference Nelson said:

“we've been public for, gosh, 10-plus years, and our TAM and our view of that roughly $5 billion TAM is a number we've had for many years. To your point, we actually think that, that number is greater than the $5 billion. And the reason for that is the way we really sized or scoped that $5 billion opportunity, it was really primarily around 2 products: our fulfillment product, which is our core product, about 80% of our revenue; and our analytics product, which provides point-of-sale and sell-through information and data to the suppliers.

And looking at the large opportunity we saw globally, that would translate to approximately 200,000 customers with an average ASP of 25,000. However, we recognize that there are opportunities, even though that's still a very large opportunity in front of us, we do have the ability to offer some, think of it as add-on products. So you buy our fulfillment products and you can buy some add-on products, will ultimately make the supplier even more efficient. All of the concepts of these add-on products would all then be additive to that TAM.

So our belief as we think the $5 billion TAM is much great. It's definitely greater than that. We just haven't updated that number yet, but the point being, it's a significantly large opportunity in front of us to get more and more customers as well as get it more and more revenue from those customers and how we'll get that revenue from the customers, in some cases, it's just as a supplier is doing business with more and more retailers and in some cases, it's going to be from additional products as well.”

It’s interesting that the commentary regarding TAM was almost 2.5 years now, and therefore the real TAM is likely multiple billions more than $5.0B at this point.

In addition to setting a medium-term growth target, SPS management has articulated an objective of reaching a 35% adjusted EBITDA margin. At the close of 2023, SPS reported an adjusted EBITDA margin of 29.4%, with anticipations of a modest increase to 29.8% in 2024. To meet their ambitious goal, SPS will need to enhance profitability by approximately 500 basis points. CFO Nelson has consistently emphasized that achieving this will largely depend on improving the cost of sales, thereby increasing the gross profit margin. There's also potential to further reduce general and administrative expenses relative to revenue, benefiting from their largely fixed nature coupled with SPS’ positive growth trajectory. However, opportunities to decrease the sales and marketing expenses ratio, currently around 23%, appear limited.

SPS has historically struggled to improve its gross margin significantly over the past decade. However, comparing with peers like OpenText, which maintains a notably higher gross margin, suggests that there is room for improvement as SPS continues to scale. Both OpenText and Manhattan Associates, which are larger entities, manage to sustain lower selling, general, and administrative costs, indicating that SPS could enhance its margins with growth.

Cost of revenue at SPS is made up of personnel costs for customer success, implementation teams, customer support and application support teams, in addition to the technology supporting them. I imagine this line item can get more efficient through artificial intelligence.

While AI presents exciting opportunities for efficiency gains, particularly in customer support sectors, it also introduces potential challenges to traditional EDI frameworks, such as those utilized by SPS Commerce. The advent of sophisticated AI capable of automating the complex extraction and interpretation of business documents could theoretically diminish the necessity for conventional EDI systems, which traditionally depend on predefined templates and intricate setup processes. However, this transformation is not straightforward. The complexity inherent in EDI—ensuring accuracy, standardization, and compliance across diverse formats and standards—poses significant challenges that may not be easily surmounted by automated AI solutions.

Reflecting on the scenario with Dick's Sporting Goods, if retailers and their suppliers were to leverage AI independently for EDI tasks, it would necessitate a substantial reallocation of resources, fundamentally altering their approach to EDI. Despite these possibilities, SPS Commerce's extensive network and deep-rooted expertise in EDI provide a robust defense. I’ll note that SPS appears to late adopter of AI. Management only mentioned AI in a conference call for the first time in July 2023, after the AI parade began. And there was no mentions in other SEC filings until the February 2024 which inserted AI as a risk. Despite that, SPS’ strength of their network and the complexity of services they provide could well insulate them from the disruptive forces of AI. This network, enriched with data and established relationships, offers a strategic moat, potentially enabling SPS to integrate AI enhancements that complement their existing offerings rather than being supplanted by them.

Valuation: To value SPS shares I created a five year DCF model. All five years have revenue projected to grow annually by roughly 15%. SPS is expected to grow slightly more than 15% in 2024 and I don’t see a reason that SPS will grow materially higher or lower than the 15% bar after that. The TAM also allows for plenty of growth for at least five years. I’m also projecting that the EBITDA margin gradually grows as well. The DCF lists reported EBITDA, instead of adjusted EBITDA. The difference has been about 8% in recent years, with the difference largely coming down to SPS removing stock-based compensation (“SBC”). SBC has crept higher as a percent of revenue and SPS will need to moderate as many other technology companies are currently moderating such costs. Assuming SBC margin stops growing, I project the EBITDA margin to be 25% in five years (2028). That would represent adjusted EBITDA of 33%, below the target laid out by management. My revenue growth estimates are ahead of what the Wall Street consensus estimate models and my margin improvement is in-line with consensus.

Other assumptions to calculate free cash flow are as follows: CapEx at about 4.7% of revenue per year, depreciation and amortization at 6.2% of revenue and a pro-forma tax rate of 25%. The other critical assumptions are the cost of capital of 7.8%, which is based on SPS’ five-year beta of 0.79, and current five year risk free rate of 4.25%. I don’t think SPS is any more or less risky than it has been in the past five years so the use of a five-year beta is appropriate. Lastly, I picked an exit multiple of 40X EV/EBITDA (LTM). Together, this calculates a fair value of about $225, which implies 26% upside in the stock price.

If you’re critical of SPS the input you may question is the exit multiple of 40X EV/EBITDA, which may seem a touch high. However, SPS currently trades at 54X trailing EV/EBITDA and the 10-year average is 49.6. Exiting at 40 therefore is justified based on SPS’ historical trading.

Another data point to justify the 40X EV/EBITDA exit multiple is the current peer comparison. I used Koyfin to screen against technology companies with a past five year revenue CAGR similar to SPSC (10% to 20%) and forward expected growth of 10% to 20%, and this basket of companies also has a 39X EV/EBITDA multiple. When you consider the options here, I don’t mind putting a 40X exit multiple, especially given SPS’ steady growth and available opportunity when comparing the remaining TAM.

Final Thoughts: SPS was a fun and interesting company to analyze. I’m particularly interested in their strong go-to-market strategy that has proven successful. CEO changes do make me a little apprehensive as an investor though Chad Collins is a suitable candidate and will have good support elsewhere on the executive roster, particularly from CFO Nelson. The company has had a history of strong financial and stock performance, and I expect that to continue. 26% upside, according to the DCF model, leaves no margin of safety. I would be an interested buyer into pullbacks, particularly below $160. Regardless, I’ll continue to monitor SPS.

Disclaimer: The content of this report is for informational and research purposes only and should not be construed as financial advice. The views expressed are my own and do not reflect those of my employer. While care has been taken in preparing this report, I make no representations or warranties of any kind regarding its accuracy or completeness. I currently hold no position in any stock mentioned. However, like any financial analyst, my perspectives may carry inherent biases. Readers are encouraged to conduct their own due diligence.

Silgan divides its business into three segments.

1. Dispensing and specialty closures segment: This segment specializes in providing innovative dispensing systems and specialty closures for a multitude of products, including food, beverages, and personal care items. By generating revenue of $2.32 billion in 2022, dispensing and specialty closures made up 36.1% of company-wide sales.

2. Metal containers business: Silgan dominates the metal container market in North America and Europe, particularly in the metal food container sector. Metal container, is the largest segment by accounting for $3.37 billion in sales in 2022, equal to 52.6% of company-wide revenue. Their leadership in this area, backed by strategic geographical presence, commands more than half the market share for metal food containers.

3. Custom containers segment: This segment produces a variety of containers for personal care, food, healthcare, and more by leveraging its capabilities through the other two segments. Custom containers generated $723.0 million in net sales in 2022, equal to 11.3% of net sales.

The company was founded in 1987 by R. Philip Silver and D. Greg Horrigan. When you merge the first three letters of Silver’s name and the last three letters of Horrigan’s last name, and divest the rest, it combines to make the company name Silgan. Silgan was largely built in the 1990s by buying assets from major canned food companies and producing cans for them under long-term agreements. For instance, Silgan bought assets from Campbell Soup in 1998 and as part of that purchase also entered into a 10-year agreement with them to produce cans for Campbell. Partnerships and relationships like the one with Campbell have been instrumental in Silgan’s growth.

Since those early days, Silgan has smartly taken the cash it earned from that initial canned business and expanded into adjacent markets. That includes cans for pet food, which has been growing at a rate higher than GDP, and in the past decade, Silgan has been focusing on the dispensing portion of packaging. Silgan focused its M&A targets in the dispensing space that includes pumps and sprayers for various end markets which has diversified the business and helped increase profit from the low-margin canned goods business.

The investment rationale for Silgan is focused on the company’s steady metal container business and also the path to high earnings growth from the dispensing business, which has become Silgan’s most important segment. The product lines are also durable and relatively sustainable, with low risk of substitutes. The valuation calculations imply 26% upside to the current stock price and there’s a case to be made for higher upside.

The rest of this analysis will cover Silgan by providing an overview of the business and the competitive environment followed by an examination of the capital allocation history, management and their incentives, capped with an outlook and valuation.

Business Overview: The cornerstone of Silgan's business strategy is the delivery of "best value" packaging products, characterized by exceptional quality, service, and technological support. Silgan's approach to maintaining its position as a low-cost producer executed through a lean organizational structure, economies of scale, investment in new technologies for manufacturing efficiency, and rationalizing plant structures.

Financially, Silgan employs a strategy of utilizing reasonable leverage to support growth and enhance shareholder returns. Right now leverage (net debt/EBITDA) stands at 4.0X, which is in line with its peers and 10-year average. This approach is underpinned by stable and predictable cash flows, primarily due to long-term customer relationships and the recession-resistant nature of its business. The company's financial tactics include leveraging its steady cash flows for value-enhancing acquisitions, repaying debt, and shareholder-oriented activities such as stock repurchases or dividend increases (I’ll dive deeper into capital allocation philosophy later in this report).

Lastly, Silgan's strategy includes enhancing profitability through productivity improvements and cost reductions. Investments in capital for productivity enhancements and manufacturing efficiencies have enabled the company to rationalize plant operations and reduce overhead costs. This approach has led to the closure of several manufacturing facilities, optimizing the company's operations. Future acquisitions are expected to contribute further to manufacturing efficiencies, economies of scale, and the elimination of redundant functions.

Shifting to segment analysis, Silgan's Metal Containers segment is the largest contributing 52.6% of consolidated net sales in 2022. This segment, particularly dominant in the metal food container market in the United States, has a market share north of 50% making it the largest maker of metal cans. Silgan's range includes steel and aluminum containers used for various food products, including pet food, soups, proteins, and fruits, as well as general metal containers for chemicals.

The company's 43 metal container manufacturing facilities, strategically located across the United States, Europe, and Asia, cater to over 50 countries worldwide. A key factor in the steady performance of the business is Silgan’s focus on multi-year customer supply arrangements, with 90% of metal container sales coming from multi-year deals.

Silgan's metal containers are favored over alternatives like plastic, paper, glass, and composite containers for products requiring high-temperature preparation, larger quantities, or long-term storage while maintaining product quality. The company’s containers, particularly preferred over glass due to their durability and lower transportation costs, also stand out for being infinitely recyclable, making them an environmentally sustainable option. Innovations such as the Quick Top easy-open ends, shaped containers, and diverse color options enhance Silgan's offerings, along with significant capital investments that boost the competitive edge of these containers in the food sector.

Silgan's marketing strategy emphasizes long-term customer relationships, with a direct sales force and a network of distributors for the custom containers business. The company's sales approach is efficient, focusing on customers within a 300-mile radius of its manufacturing plants to minimize transportation costs. Major clients for these products include well-known brands like Campbell, Nestlé and Conagra Brands . Nestlé in particular has been Silgan’s largest customer representing 13% of company-wide sales in 2022, up from 12% in 2021 and 11% the year before that. No other customer accounted for more than 10% of company-wide revenue.

The Metal Containers segment's performance is influenced by factors like regional vegetable and fruit harvests, especially in the United States and Europe. This seasonality affects the segment's sales and operations, often leading to higher sales volumes and a significant portion of annual income in the third fiscal quarter. Compared to the two other segments, Metal Containers are relatively recession-proof as they lean toward consumer durables products.

According to the latest 10-K filed in February 2023, the metal container segment has grown at a CAGR rate of approximately 7.6% since its inception in 1987. For this analysis, I extracted segment financials through 2007. Silgan doesn’t clearly disclose organic growth, which is unfortunate because it’s difficult to decipher how much M&A is contributing to top-line growth. The following financial data is taken from 10-Ks that list segment performance. Metal containers have grown its revenue at a CAGR rate of 4.8% since 2007 and only three years had materially negative performance. That includes 2016 when deflation dragged sales lower and 2023 due to customer destocking. This follows strong top-line growth in 2022 when Silgan passed through high material cost increases.

Silgan historically reported 'segment income' for each of its business segments, reflecting the operating profit (EBIT) generated by each segment independently. The total segment income represents the company-wide operating profit, adjusted for corporate-level charges that are not assigned to specific segments. However, in 2023 Silgan began reporting adjusted EBIT by excluding: acquired intangible asset amortization expense, pension expense (income) and rationalization charges and costs attributed to acquisitions. I much preferred the GAAP EBIT disclosure because acquiring companies is part of Silgan’s DNA and costs to do so shouldn’t be excluded. They often have rationalization charges because they optimize footprint for the current customer base as well. If they’re repeated/consistent costs they should be left in. But that’s modern investment accounting for you. The segment analysis will cover data from 2007 - 2022 and then I’ll give an update on 2023 performance in the company-wide

Metal containers, in particular, has had an average operating margin of 9.5% in the past 15 years. It’s generally seen a decrease and was low in 2022 due to exiting Russia operations that increased rationalization charges (one-time expenses generally used for cost-cutting initiatives). Excluding rationalization charges in 2022, the operating margin would’ve been about 9.1%, in-line with its historical average.

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Transitioning from the Metal Containers segment, Silgan's Dispensing and Specialty Closures business is the second largest segment accounting for 36.1% of the company's consolidated net sales in 2022. Silgan offers an expansive array of dispensing systems and specialty closures, catering to a diverse range of industries including food, beverage, healthcare, personal care, and beauty products. This segment, with 46 manufacturing facilities across North America, Europe, Asia, and South America, effectively serves over 100 countries, highlighting Silgan's extensive global reach.

In terms of product range, the dispensing and specialty closures business covers a broad spectrum. These include dispensing systems for various applications, from healthcare sprays to beauty and food products, and specialty closures for a multitude of food and beverage items. Recent acquisitions like the Albéa Dispensing Business and Gateway Packaging have further enriched Silgan's portfolio, expanding its capabilities in pumps, sprayers, foam dispensing solutions, and precision dosing. These additions have also broadened the company’s reach into new markets, including Point-of-Care diagnostics. It also prompted Silgan to slightly change the name of the segment to dispensing and specialty closures from just “closures”. The new, longer name gets abbreviated to “DSC”.

The manufacturing processes for these products are sophisticated, utilizing compression and injection molding techniques for plastic closures and advanced multi-die presses for metal closures. This manufacturing expertise enables Silgan to offer an array of customization options, including various decorating choices, to meet unique customer needs and regulatory requirements.

Silgan's customer base in this segment is both extensive and prestigious, featuring names like Campbell, Coca-Cola , and L'Oréal. Additionally, Silgan's strategy of licensing its technology to other manufacturers further extends its global footprint, ensuring its presence in markets not directly served by the company. This comprehensive approach in the Dispensing and Specialty Closures segment underscores Silgan's commitment to quality, innovation, and customer satisfaction.

Since 2007, reported revenue for the dispensing segment increased at a CAGR rate of 9.2%, which is by far the strongest of each of the segments. In 2007 this sector made up 21% of company-wide sales, which is up to 36.1% in 2022. The relative outperformance largely reflects acquisitions and some organic investments. The biggest jump in revenue was in 2017 when Silgan acquired WestRock (WRK)’s specialty closures and dispensing business. The worst year was 2015 when the closures business was weak due to foreign currency translation and lower material cost pass-throughs. Management over the years has smartly built this business and it should be noted that operating profit margins have been gradually increasing. In 2008 the profit margin stood at 8.8% and that’s increased to 13.9% in 2022, which compares to an average of about 11.5% over the 15-year period.

The last segment in Silgan's arsenal is the Custom Containers business, formerly known as Plastic Containers, accounting for 11.3 percent of the company's consolidated net sales in 2022. This renaming coincided with Silgan changing the name of the closures segment amid the acquisition of Albea in 2020. The change from plastics to custom containers implies a broader array of solutions offered by Silgan.

As a leading manufacturer in North America, the Custom Containers segment specializes in high-density polyethylene (HDPE) and polyethylene terephthalate (PET) containers. HPDE is a strong opaque plastic used for things such as laundry detergent whereas PET is a clear plastic for products like water or mouthwash. These custom-designed containers cater to various markets, including personal care, healthcare, food and beverage, and household chemicals.

The segment's prowess lies in its ability to rapidly respond to customer needs for design, development, and technological support. Its diverse product line results from its capacity to produce containers from a full range of resin materials, using various manufacturing, molding, and decorating techniques. State-of-the-art decorating equipment and methods like in-mold labeling and post-mold decoration further enhance the appeal of these containers. This versatility positions Silgan to meet the evolving and innovative packaging needs of its customers.

Resins like virgin HDPE and PET, along with recycled materials, form the backbone of Silgan's raw materials in this segment. The company has secured multi-year arrangements with several major resin suppliers, ensuring a steady supply despite market fluctuations. Most customer agreements in this segment include clauses for the pass-through of changes in resin costs, providing financial stability and predictability.

Marketing for Custom Containers is done through a direct sales force and a vast network of distributors, reaching a variety of markets across North America. Major clients include McCormick, General Mills, and Johnson & Johnson, among others.

Financially, custom containers had a forgettable decade for most of the 2010s. Since 2007, the segment has grown revenue at a CAGR rate of just 1.0%. The lag meant the segment went from making up 21.5% of company-wide sales in 2007 to just 11.3% in 2022. However, the business has improved, particularly segment income which has grown at a CAGR rate of 3.3%. Note that profit margins have grown to 12.8% in 2022 from ~1.0% in both 2015 and 2016 when plastics was at its worst.

After running through the segments, it’s no surprise the (dispensing and specialty) closures segment has steadily been making up more and more of the company-wide revenue, while custom containers has been the shrinking piece of the pie. What’s most fascinating is that profit from the closures and dispensing now makes up half of company-wide EBIT. This is largely due to the increase in margins for that segment, which has now become the most important business for Silgan.

On an aggregate level, the financial figures feature Silgan’s revenue CAGR of 5.4% since 2007 where revenue rose from $2.9B in 2007 to $6.4B in 2022. The growth in operating profit has been similar during that 15-year period by growing at CAGR of 5.6%, which also shows that margins have been steady (profit and sales have grown at similar rates).

With the dispensing acquisitions — Albea and a portion of WestRock — Silgan has evolved from a consumer staples-focused containers company to a more diversified consumer packaging company. There’s a potential for the consumer discretionary end markets to drive more growth while also having the metal containers segment offset poor performance of the rest of the business in an economic downturn. That theme can be seen within segments because Silgan offers closures for premium glass packaging products food and also plastic. Think about the types of products that come in glass and plastic, such as ranch or syrup. Glass is the pricier, discretionary option whereas plastic represents the inexpensive option that consumers may trade down to.

Competition: In the competitive world of packaging, Silgan stands out with its well-established customer relationships and a business model that thrives on multi-year contracts. This approach has allowed Silgan to carve out a steady position in an industry where strong customer ties are as important as innovation.

In the Dispensing and Specialty Closures space, Silgan faces competition from notable players like AptarGroup and Berry Global Group. Silgan's strength lies not just in the range of its products but also in its capacity to meet diverse customer needs across various industries. From food and beverage to personal care, Silgan offers solutions that go beyond just packaging – they deliver reliability and quality, crucial in retaining customer loyalty in a sector where choices abound.

In the Metal Containers segment, Silgan stands out in an industry where choices abound for customers, ranging from self-manufacturing to opting for various material alternatives like plastic, paper, glass, and composites. Despite this array of options, Silgan holds a significant advantage, thanks to its strategic approach and the inherent strengths of metal containers. The key to Silgan’s success in this space lies in understanding the specific needs of the products that metal containers hold. Metal is often the preferred choice in situations where products are subjected to high temperatures during preparation or require long-term storage. This is because metal containers are excellent at preserving the quality of their contents under such conditions. Furthermore, when it comes to larger consumer or institutional quantities, metal containers offer durability and cost-effectiveness that other materials struggle to match. Their robust nature makes them more desirable than glass containers, especially when considering the lower transportation costs and reduced risk of damage.

Additionally, Silgan recognizes the growing environmental consciousness among consumers and businesses. Metal containers are not only one of the most recycled packages globally but are also infinitely recyclable, aligning well with the increasing demand for sustainable packaging solutions. Comparatively, some packaging peers produce plastic products that are criticized for their toll on the environment.

Silgan's strategic positioning of its manufacturing plants within a 300-mile radius of its customers is another crucial aspect of its competitive strategy. This proximity offers logistical advantages and cost efficiencies, both of which are vital in maintaining strong customer relationships. However, this also brings a level of dependency on the geographical stability of key customers, as major relocations could impact the business.

In the realm of custom containers, Silgan competes with the likes of Amcor and Berry. Despite this, Silgan holds its own, thanks to its quick response to customer design and development needs and a diverse product line. Being adaptable and customer-focused is key in this segment, where innovation in resin composition and changing manufacturing technologies are pivotal.

Financially, Silgan's relative performance has been steady, though not spectacular. With a 10-year CAGR stock performance of 7.6% and an EBIT profit margin of around 10%, Silgan's numbers are solidly average in the industry. This steadiness is reflective of a business underpinned by long-term contracts and a consistent approach to customer relationships. This profile might not make headlines for flashy growth numbers, but it provides a foundation of reliability and predictability – valuable commodities in a competitive landscape.

Capital Allocation: To frame how management of Silgan has spent its capital, and how much it relied on M&A, I’ll review capital allocation over the last decade. Silgan generated $4.7B in cash from operations in the 10-year period from 2013 to 2022. A hefty 41.0% of that cash from operations was reinvested back into the company via capital expenditure, the modest dividend made up 10.1% of the cash from operations, and 18.9% of the cash from operations was spent on buybacks during the period. It’s no surprise the largest component of capital allocation has been acquisitions, with $3.0B spent on acquisitions, according to cash flow statements, equal to 63.6% of the cash from operations. Before extracting these numbers, I expected the percentage spent on CapEx to be less and the percentage on acquisitions to be higher. But there’s not been a significant transformative merger and so Silgan’s spending on M&A hasn’t been equivalent to serial acquirer status.

The first material acquisition in the past decade was for Portola Packaging for $262M (net of cash acquired) in 2013. Portola specializes in plastic caps for closing various food and beverages. “We believe that the acquisition of Portola broadens our global closure franchise," former CFO Bob Lewis said at the time. There were no material transactions in the three years after until 2017 when Silgan acquired WestRock’s Specialty Closures and Dispensing Systems Business for $1,024M in April 2017. This was a cash deal that was largely funded by debt. When it was brought under Silgan, it was renamed Silgan Dispensing Systems and made triggers, pumps, sprayers and dispensing closures for health and beauty, and garden as well food products. Former CEO Tony Allott said of the acquisition:

“We are particularly pleased with this acquisition as it's a business that we've literally had our eye on for over a decade. The reason for that is we think it's such a great fit in terms of the markets served, the approach to markets and customers, the technology that is deployed by the business, and the strong cash return nature of the business”

After a two-year break, Silgan was busy again with acquisitions in 2020 and 2021. Silgan’s acquisition of Albea in June 2020 was for $901M and effectively made the dispensing offerings more complete by manufacturing foam pumps for personal care (soaps) and bolstered sprayers for beauty such as misting and lotion pumps. In September 2021 Silgan acquired both Gateway Plastics and Unicep Packaging for $484M and $237M, respectively, and combined for another solid year of acquisitions.

Silgan’s appetite for acquisitions in 2022 and 2023 has been limited. For some companies, it can be easy to balance growth via internal investments and M&A. Silgan’s existing businesses are mostly mature and exhibit low growth so any growth above GDP is more likely to come from M&A. It’s worth being aware the returns from M&A can shrink when the philosophy entails issuing debt if the price of debt is elevated (such as 2023). Instead, Silgan shifted to stock buybacks with about $150M spent in Q3’23 alone after the stock pulled back, which reflects their opportunistic return-based capital allocation philosophy.

Silgan generated free cash flow (“FCF”) of $1.95 per share in 2013, which grew to $4.84 per share in 2022, representing a CAGR of 10.6%. That period includes poor performance in 2014 and 2015 when Silgan went through a rough patch of slowing growth and decreasing margins. As noted, Silgan is experiencing a downturn in 2023 and is expected to generate $3.19 in FCF per share. That decrease would still represent an annual growth rate of 7.7% against 2014 (10-year difference).

As a comparison, Berry Global generated $11.5B in cash from operations in the 10-year period of fiscal 2014 to fiscal 2023 (ended September 2023). $4.3B (37.6% of cash from operations) went toward CapEx, $1.4B (12.3%) was used for buybacks and $9.4B (81.7%) was spent on acquisitions, net of divestitures. Berry only began paying a dividend in fiscal 2023 which was equal to 7.9% of the cash flow for the year but the 10-year dividend allocation is therefore quite limited. Overall the difference in capital allocation shows Berry spent relatively more on M&A and less on dividends in the past decade compared to Silgan.

Berry had two notable outsized acquisitions in the past decade. The first was for Avinitiv in fiscal 2016 for $2.26B in cash (net of cash acquired). Avinitiv was a materials maker for hygiene and personal care products to companies such as Proctor & Gamble (PG) and Kimberly-Clark. (Berry put its health and hygiene business up for sales in September 2023 but there haven’t been takers yet.) Berry then spent $6.1b on RPC Group PLC, a European-based maker of plastic packaging and some select non-packaging plastic products. The deal was also paid for in cash and financed through debt, indicating their playbook matches Silgan where the packaging companies eschew issuing shares in favor of debt. These transactions helped bring Berry’s FCF per share to $7.84 in fiscal 2023, up $2.68 in fiscal 2014 (12.7% CAGR in the 10 years). You can see their FCF per share was increasing at a faster clip before those two transactions, which have coincided with decreasing profit margins in recent years.

Management and their incentives: Silgan has been led by Adam Greenlee as CEO since September 2021. Greenlee, 50, already has a long tenure with Silgan having joined the company in 2005 as EVP of North American operations of Silgan White Cap. He worked in increasing responsibilities in operations roles until he was named COO in August 2009 and president in 2019.

Silgan also replaced its CFO from within by promoting Kimberly Ulmer to the top financial role in March 2023. Ulmer initially joined Silgan from General Electric (GE) in 2004 as controller. From 2018 to 2023, Ulmer worked as VP and then SVP of finance. Note that Ulmer took over as CFO in 2023 from Robert Lewis, who was CFO for nearly 19 years. As part of the succession plan, Lewis down-shifted his responsibilities and remains with the company as EVP, corporate development and administration. I was drawn to Silgan because of their savvy returns-based capital allocation practice and while it can be discouraging to see a recent CFO turnover, it’s comforting that Silgan has slowly onboarded Ulmer while keeping Lewis close by.

The last notable member of the executive management team is Thomas Snyder, who is the second highest-paid officer. Snyder has been President, Silgan Containers since 2007, leading the metal container business. Snyder is also a long-tenured executive whose initial role in 1993 was as a national account manager for the containers business.

The compensation philosophy consists mainly of a base salary, annual stock awards and stock-based compensation paid in the form of restricted-stock units (“RSUs”) and performance awards of restricted stock units (“PSUs”). Adam Greenlee, while CEO, and his predecessor Anthony Allott were paid 13% of their total compensation in salary and 13% paid in the form of the annual cash bonus. Roughly 64% of total compensation was paid in the form of stock awards while the remaining 3% was paid through other means (401K and dividend equivalents associated with RSUs). Other executives besides the CEO (“NEOs”) had a higher proportion of total compensation paid in the form of salary (28%) and a lower proportion from stock awards (50%).

The more important insight to get from the compensation plan is the actual incentive metrics used. Starting with the annual bonus, Silgan focuses on adjusted EBITDA to determine the size of bonus payouts. CEO Greenlee has a target bonus of 100% of his salary, but can earn a maximum of 200% of his salary. Other named executives have a target and maximum bonus equal to 60% of their salaries.

Note for this section I’m going to write and discuss CFO compensation as attributed to former CFO Robert Lewis, but the characteristics will generally match what newly promoted Kimberly Ulmer will receive. Silgan splits the cash bonus plan in a few categories with CEO Greenlee in one camp, unit heads Jay Martin (plastics) and Thomas Snyder (metal containers) in another camp with bonuses tied to their units. The third camp is CFO Lewis/Ulmer and General Counsel Frank Hogan (“Holdings Executive Officer Program”) who have incentives tied to company-wide performance but are separated from the Senior Executive Performance Plan that Silgan places the CEO in. There’s some ambiguous language for goals and I think Silgan could’ve done a better job at clarifying goals.

As noted, Silgan uses adjusted EBITDA for the annual cash bonus. There is a lot of adjustments. Anything that’s remotely non-recurring is removed, “subject to further adjustment as determined by the Compensation Committee for acquisitions and/or divestitures”. The target amount of adjusted EBITDA to earn the maximum bonus is simply the prior year’s adjusted EBITDA implying management does not need to grow the business to earn its bonus. And while the CEO’s plan allows for a bonus equal to 200% of their salary, it always gets paid out at 100%, which is a bit strange.

Recall about 64% of the CEO pay is paid in stock and about 50% of total compensation for other executives is paid through stock awards. Of that, Silgan pays most of it in performance awards with the remaining minority in RSUs that vests without performance goals attached. The specific incentive for the performance awards is again adjusted EBITDA. The minimum amount is 75% of the prior year’s adjusted EBITDA, which is an admittedly low bar. Most companies have multiple goals for different payout levels. Silgan’s writing is ambiguous but does imply management gets the full payout for earning 75% of the prior year’s amount. Exact text is as follows:

“For grants made in 2022, the Compensation Committee established in 2021 the Company's Adjusted EBITDA, subject to adjustment as determined by the Compensation Committee for acquisitions and divestitures, as the performance criteria and the minimum level of performance by the Company for 2021 as 75% of the Company's Adjusted EBITDA level in 2020. At the time the performance criteria is set for a particular year, the Compensation Committee approves a maximum number of restricted stock units that may be granted to each individual in the following year if the Company attains the minimum level of performance.”

Also note that the financial metric is a one-year goal then the performance stock is certified and vests over five years. There’s an interesting line of text from the proxy that speaks to the philosophy of the compensation plan:

“The minimum level of performance required to be attained for grants to be made in the following year is set by the Compensation Committee at a level that, although not certain, should be attainable because the primary purpose of these grants is retention.”

It’s strange the board of Silgan views the compensation plan as simply a tool to promote retention rather than using it to incentivize management to increase shareholder value. In order to benefit shareholders, this compensation plan should be overhauled with some incentives tied to growth/revenue. Or at least increase the target amounts of adjusted EBITDA Silgan needs to earn in order for management to get bonus and performance stock payouts.

As a comparison, Berry’s annual cash bonus is paid out based on a mix of adjusted EBITDA, free cash flow, and a reduction of greenhouse gas emissions. The larger, equity-based component consists of 40% stock options and 60% performance-based stock. The PSUs are tied to total shareholder return (“TSR”) and return on capital employed (“ROCE”). Generating TSR that’s equal to the median of its peer group and a ROCE of 14% earn the target amount. I find the inclusion of free cash flow targets and a clear ROCE target of 14% beneficial.

Outlook: Silgan is a durable company that features the metal container business. Given that 53% of revenue is from making cans, and most of that is for human food, Silgan’s fortunes will likely be tied to the broader economy for the near and long-term. Silgan has the ability to organically grow faster than GDP due to its current portfolio that’s beginning to tilt into higher growth businesses.

Within the metal container segment, close to half is from the pet industry, with most of that coming from cat food in particular. Volume growth of pet food has been strongly outperforming human food growth over the last decade and it’s a tailwind that’s likely to continue for many more years. It’s also worth acknowledging that cat food from a can, while a premium compared to dry food, is generally recession-proof because cat owners don’t swap back and forth. The remaining portion of the metal containers is also largely made up of recession-proof food staples which has supported the company in previous recessions. It’s easy to get a meal out of a can for $2 or less, which is quite difficult for many other food items. My personal favorite in that category is Cattle Drive chili from Costco; such a great deal under that $2.00 mark.

Silgan is also nicely positioned for sustainability. There’s two angles to this: 1) a willingness to buy products that are recyclable and 2) lack of more sustainable substitutes. Silgan’s head of investor relations, Alexander Hutter, participated in the Gabelli Waste & Sustainability conference in May 2023, providing insights that were pertinent to the outlook. Among the topics discussed were that 95% of the products Silgan makes company-wide are recyclable. Cans in particular are “infinitely recyclable” and are the “most highly recycled food or beverage package”, according to Hutter. Hutter also touted the reduction in greenhouse gases through canned food, because you don’t need to refrigerate the food. That difference seems incremental at best, however, canned foods do help reduce food waste so there is some clear sustainability impact in the end-product. In terms of substitutes, cans won’t be easily phased out through technology unless food consumption drastically changes in a Wall-E like world. Hutter had this quote:

“in terms of substrate substitution, I think this is one of those kind of franchise hallmarks within Silgan that was built into the business from the beginning. So if we just go across the segments, within the Metal Container business it's important to understand that the food that's in the food can is cooked in the can. So switching to another substrate like a plastic pouch, right, is extremely costly for our customers…there's a fully depreciated filling and cooking asset base that many of these customers that we have really all of them have within their own operations. It's highly efficient for them to run through their -- through their current thermal assets…

In our Dispensing and Specialty Closures business, so those products are predominantly metal and plastic, but mostly on the plastic side within dispensing, there's not really a substrate that can replicate the attributes that those products make in terms of product dispersion, if you think about something like a fragrance spray, right, you're not going to be able to do that with something that's made out of metal. Now you can bring metal components into that. But the issue there is that, that makes that product then not recyclable….The metal closures that we make within the Dispensing and Specialty Closures business, which is about 1/4 of the revenue in the segment. Those have all the same attributes that our metal cans have in terms of recyclability and recycling rate.

And then as we look to some of our some Custom Containers products, Those, again, we've stayed away from across our portfolio, doing things that are single serve. So we don't do water or carbonated soft drink, closures or bottles. What we focus on really are multi-serve applications. So if you think about like a shampoo bottle, right? It's unlikely that consumers are going to take a glass bottle back into the shower anytime soon. So those are the types of products that we focused on driving kind of our growth on. So from a substitution standpoint, don't think that there's much risk there….

But I think more recently, metal packaging, obviously, has taken off as a sustainable package. And so we've been spending more resources in terms of investing in R&D and bringing new packages for things that haven't been in metal packaging before things like K-Cups for coffee or metal yogurt cups and things like that. So bringing those solutions to customers again, there's always a cost element that goes with that for customers. But I think it's maybe reinvigorated some of the growth in the business as well.

The last theme to note in regards to outlook is the relatively higher growth to be expected from the dispensing and specialty closures segment. Overall this business can expect mid-single-digit organic growth in the coming years, propelled by potential double-digit growth in most dispensing products (fragrance sprayers etc.) that will be offset by the legacy closures (bottles caps). Dispensing is now the majority of that segment, making it a niche to watch, especially since it can carry Silgan to a higher-margin territory.

Valuation: Silgan reports Q4’23 earnings on January 31 and it’ll be meaningful to see quarterly revenue reverse the trend of deeper negative growth. YoY revenue for the quarter turned slightly negative in Q1’23 due to customer destocking and tough strong comparable figures in 2022. Growth contracted further to -7.6% in Q2’23 and more recently -8.5% in Q3’23. The current sell-side estimate for Q4’23 is $1.39B, which would imply -4.5% YoY revenue growth, suggesting a move back toward positive territory. I don’t focus on quarterly forecasts. Instead, I have a longer-term mindset and favor a five-year forecast (just enough to feel like I’ve got a grasp of the financials but not too long where you need a crystal ball).

The DCF forecast to value Silgan has segment forecast of revenue. All three segments will be negative in 2023 and I forecasted a recovery in 2024 with consolidated revenue of $6.37B, which is slightly lower than the high-water mark set in 2022. The dispensing segment is expected to carry mid-single digit growth during the forecast period while metal containers and custom containers will exhibit relatively lower growth. Note this forecast doesn’t assume any M&A, which would push reported revenue higher.

EBITDA margins are expected to be poor in 2023 due to further rationalization charges that coincide with the latest “cost reduction program” that will yield $50M in cost savings, according to Silgan management. The forecast then includes a gradual rise in EBITDA margins to 15.0% by 2027. Silgan’s highest EBITDA margin (including non-recurring costs) was 14.9% in 2020. In my opinion this is easily achievable if the Dispensing segment continues to make up a higher proportion of sales. Dispensing in particular had an average EBITDA margin of 17.7% in the last decade, compared to 13.4% company-wide. Moreover, dispensing achieved a 20.2% EBITDA margin in 2022, compared to the company-wide figure of 13.5%. The point is that this is a higher-margin segment that continues to make up a larger piece of the pie..

Some simple assumptions to calculate free cash flow are as follows: CapEx at about 4.1% of revenue per year, depreciation and amortization at 4.3% of revenue and a pro-forma tax rate of 22%. The other critical assumptions are the cost of capital of 5.8%, which is based on Silgan’s two-year beta of 0.82, and current five year risk free rate of 4.0%. Lastly, I picked an exit multiple of 9.5 EV/EBITDA (LTM). Together, this calculates a fair value of about $55, which implies 27% upside in the stock price.

One of the most powerful inputs in a DCF like the above is the exit multiple. 9.5X EV/EBITDA is the 10-year average. However, it’s worth noting that if Silgan can shift toward a higher-margin business it would lead to stronger earnings growth and shares could command a higher multiple than the historic average. With that consideration, there’s room for further upside in the bull case. The bear case is continued low margins which would imply shares are closer to fair value.

Final thoughts: Silgan is a well-managed packaging company that has executed compelling acquisitions in recent years to take this metal can maker to a new stage. The durability and sustainability in the business products are admirable during a time when many around the globe are criticizing non-sustainable packaging. The stock and the underlying financials have historically had very average performance. With the business coming out of a trough, it makes for an intriguing investment for those looking for a steady business tied to consumer demand. Given the fair value estimate of $55.00, it’s solid upside for a mid-cap packaging company. Overall it’s hard for me to have confidence that Silgan is a material outperformer. The company has historically had aggressively medium performance. The probability they outperform, via earnings growth, outweighs the probability of underperformance.

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Disclaimer: The content of this report is for informational and research purposes only and should not be construed as financial advice. The views expressed are my own and do not reflect those of my employer. While care has been taken in preparing this report, I make no representations or warranties of any kind regarding its accuracy or completeness. I currently hold no position in any stock mentioned. However, like any financial analyst, my perspectives may carry inherent biases. Readers are encouraged to conduct their own due diligence.

OSI has three segments and is known for their largest segments, the security division, which is at the forefront of keeping us safe. Think of all the places where security is non-negotiable: airports, borders, government buildings. OSI provides the scanners and systems that scrutinize everything from luggage to cargo, making sure threats don’t slip through. OSI’s security offerings are differentiated through its cargo scanning products that are used at borders for more seamless trade between countries.

The healthcare segment focuses on patient monitoring through sensor products such as electrocardiographs. Then there's the Optoelectronics and Manufacturing business that creates tiny but powerful parts that go into all sorts of devices for sensing light in industrial settings. In essence, optoelectronics and the two other segments all leverage the same technology, with optoelectronics making the small technology tools that go into their healthcare and security products, and products of many other industries by serving outside customers in addition to internal customers.

The investment rationale for OSI is a continued need for security products and an increasing need for cargo scanning products in a world that’s increasingly connected economically. OSI has landed some large contracts in the past two years and has a backlog that’s at its highest level ever, driven by strong book-to-bill ratios. Revenue is expected to accelerate in calendar 2023 and I view shares as undervalued with a fair value estimate of $185, which is 42% above the current stock price.

The rest of this analysis will cover OSI Systems by providing an overview of the business and the industry dynamics followed by an examination of the capital allocation history, management and their incentives, capped with an outlook and valuation.

Business overview: The largest segment for OSI systems is the security segment which made up 59.5% of company-wide revenue in fiscal 2023 (ended June 30, 2023). The security division plays a pivotal role in the global landscape of security and inspection, a market that has become increasingly vital in today's world. This segment underscores the critical nature of security in various sectors and OSI has a substantial presence in the field.

The security and inspection market is driven by a wide range of technologies, including X-ray, computed tomography, metal detection, and radiation monitoring, among others. OSI, primarily operating under the "Rapiscan" trade name, has positioned itself as a key player in this industry. The demand for such products is fueled by ongoing concerns over terrorism, drug and human trafficking, gun violence, and the need for stringent government security regulations globally. OSI's products find their applications not just in airports, but also in border crossings, seaports, correctional facilities, government and military installations, and at major sporting and cultural events. OSI’s Rapiscan will be the primary security detection provider of the 2024 Olympics in France, and was also the leading security provider for the FIFA World Cup in Qatar and London Olympics in 2012, all of which help build brand recognition.

OSI's security products are diverse, ranging from baggage and parcel inspection to sophisticated systems for scanning cargo, vehicles, and even people. The technology employed is state-of-the-art, including dual-energy X-ray imaging and advanced algorithms, enhancing the detection of contraband such as explosives, weapons, and narcotics. The company's ability to adapt its systems to changing customer requirements and regulatory standards is a testament to its commitment to innovation.

The Security division's products vary in scale from compact, handheld devices to large systems capable of inspecting shipping containers and trucks. These systems employ a combination of transmission imaging and backscatter imaging, the latter being a technique that detects X-rays scattered back towards the source, effectively revealing objects on or near the surface being scanned. OSI has also developed specific technologies in some cases to meet the unique security requirements of government customers.

The customer base for these products is extensive and includes numerous U.S. government departments, as well as international government agencies and private sector clients. This wide-ranging clientele reflects the universal need for security across different sectors and geographies. OSI's ability to offer tailored solutions, complying with various international performance standards, sets it apart in the marketplace.

One of OSI's notable strengths is its ability to provide turnkey security solutions. This includes not just the supply of equipment but also the construction, staffing, and operation of security screening facilities. Such comprehensive service offerings ensure that OSI can meet the diverse and evolving needs of its clients. Turnkey projects also allow for bigger installed bases with more services, and lead to more success for the customer and higher margins for OSI.

The security segment has increased its revenue from $372.2M in 2013 to $760.3M in 2023 for a compounded annual growth rate (“CAGR”) of 7.4%. Over that period, there have been two years with significant drops in revenue. The first was 2016 when a large government contract lapsed, pulling down the growth that year. The other was in fiscal 2021 when the aviation and cargo business was impacted by COVID-19 with customers pushing out delivery of orders. Relative to the other segments, operating profit margins have been healthy by averaging about 12% since 2012. In addition, operating profit has grown at a faster clip than revenue increasing from $43.7M in 2013 to $115.0M in 2023 for a CAGR rate of 10.1%.

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OSI Systems' Healthcare segment, under the Spacelabs banner, accounts for a modest 14.9% of the company's revenue as of 2023, making it the smallest slice of OSI's business pie. The segment's presence in the healthcare market is propelled by growth in global healthcare needs, fueled by demographic trends and technological integration. However, this is a narrative of struggle more than success, with a CAGR of -1.9% over the past decade.

Spacelabs has a deep history as it was founded in 1958 by a pair of scientists who developed cardiac monitoring systems for NASA. Their products were then used for wireless monitoring for vitals for astronauts in Gemini and Apollo missions. According to the company’s website, Neil Armstrong stepped onto the moon wearing Spacelabs telemetry (EKG/heart monitoring). Now that we’re decades past those early pioneer days, results have been underwhelming.

While the healthcare industry burgeons, propelled by expanding middle classes in developing regions and the silver wave of aging populations in more developed nations, OSI's Healthcare division appears to be in a bit of an operational malaise. The segment's offerings—patient monitoring systems, cardiology, remote monitoring, and connected care solutions—are amid a highly competitive market where innovation is relentless, and customer loyalty is hard-won. The demands of the sector have escalated, with providers being pushed to deliver more value with less overhead, a challenge compounded by the regulatory rigmarole and economic uncertainty, particularly within the U.S. healthcare landscape.

OSI's foray into the healthcare tech market with Spacelabs products aims to meet these challenges head-on. However, there's an undercurrent that perhaps their offerings may not be entirely in step with the cutting edge of medical technology. While they tout patient monitors and systems like Xprezzon and Qube, and highlight the SafeNSound platform for its workflow and communication efficiencies, I wonder if these solutions are truly differentiating themselves in a crowded field or if they're losing their footing compared to more agile competitors who are quicker to integrate the latest in medical tech innovations.

Their predictive analytics and clinical decision support tools, including the FDA-cleared Rothman Index, suggest a stride towards modernization, but there's a suggestion that such advancements might not be enough to outpace the competition or fully meet the shifting demands of healthcare providers.

In cardiology, OSI's digital telemetry systems and ECG management tools like PathfinderSL and Lifescreen™ Pro aim to streamline and enhance cardiac care. Yet, the concern lingers—do these products offer anything that can't be found elsewhere, perhaps with more sophisticated features or at a better price point?

The market for OSI's healthcare products is broad, spanning hospitals, clinics, and surgery centers worldwide, with efforts to penetrate markets through direct sales and networks like the NHS Supplies Organisation and UGAP in France. But despite this reach, the numbers tell a tale of a segment not quite hitting its stride.

Financially, this segment has been the weakest over the past decade. Revenue has gone from $231.3M in 2013 to $190.5M in 2023 and there’s not been any material divestitures artificially pulling that down. (As noted CAGR of -1.9%.) The average operating margin since 2013 of 7% also lags the other segments. OSI does segment reporting of operating profit, depreciation and amortization (to arrive at EBITDA), segment assets and CapEx. While they don’t give gross profit, the 10-K states healthcare has had the highest gross margin of the three segments. Recall the difference between gross profit and operating profit is selling general & admin expenses and R&D expenses, so those two line items must be notably higher for healthcare on a relative basis. Operating profit of $25.2M (10.9% margin) in 2013 fell to $11.4M (6.0% margin) in 2023. Outside of a couple strong years in 2021 and 2022 amid higher demand during covid, operating margins have generally fallen over the last decade.

The third and final segment is the optoelectronics and manufacturing division, which made up 25.6% of company-wide revenue and has had a healthy growth trajectory over the past decade. The products and services under OSI's Optoelectronics banner range from active components, like those sensing light for conversion into electrical signals, to passive components that manage light without altering its energy. These components are crucial in applications like medical diagnostics, satellite navigation, and homeland security. Some examples of end markets include components in satellite navigation systems for aerospace, laser-guided munitions systems within the defense industry, laser-based remote sensing devices for classifying vehicles for traffic management and industrial automation. The customers for the optoelectronics are quite diverse spanning consumer and industrial industries. CEO Deepak Chopra made this comment in the October 2023 earnings call:

“[Optoelectronics has] a very predictable customer base. We work with the OEMs, and we continue to look at it…The thing that really makes us very, very good compared to our competitors, one is, we've got a very broad customer base from aerospace, defense, to automotive, medical, consumer, name it, we're in all spaces.

"So as a group, all those areas, some are weak, some are strong. And the second thing that we keep saying it, and I've said it before, and I said it again, our global presence of manufacturing is a big advantage. And lately, you've heard it everywhere that there's a lot of talk about alternate to China. And we have the ability, both in Asia and in U.S. and in Europe to manufacture products from our customers. So we look at this business as a very well thought out business, predictable business.”

The company provides a full suite of manufacturing services, including printed circuit board assembly and box-build manufacturing. Their reach in manufacturing extends to providing components that bolster the security and healthcare segments of OSI, indicating an integrated approach to their business model.

The Optoelectronics segment has ridden the wave of technological progress, where cheaper and more powerful computing capabilities have expanded the use of optoelectronic devices across a slew of industries. OSI has seized this opportunity, positioning itself as a specialized manufacturer with a broad spectrum of expertise. This specialization enables the company to meet the quick turnaround times and specific requirements of original equipment manufacturers (OEMs), catering to sectors as diverse as aerospace, defense, medical imaging, and telecommunications.

The optoelectronics segment has been a good source of growth for OSIS with revenue (from external customers) that increased from $198.5M in 2013 to $327.6M in 2023 for a CAGR rate of 5.1%, which is between the two other segments. Note that optoelectronics plays a vital role as a supplier to the security and healthcare segment by acting as a supplier for their products. As such, optoelectronics reports revenue to external customers and also intercompany revenue. For 2023, external customer revenue was $327.6M and intercompany revenue was $59.8M, making total revenue for the segment $387.4M. The intercompany revenue has generally been around 15% of the segment sales for optoelectronics. In addition, operating profit margins have also been healthy by averaging ~11% since 2013 with some margin increases in the past two years with operating profit margins in 2023 at 14.2% (operating profit divided by external customer revenue).

Below is the shift in the business mix which has gradually shifted more towards the security segment and optoelectronics, while the healthcare segment has been a shrinking piece of the pie.

OSI as a whole has seen its revenue increase at a CAGR rate of 4.8% since 2013 while operating profit has increased at a CAGR rate of 6.2% indicating OSI has focused on profits over revenue in the past decade. The growth in the past decade is solidly lower than the prior decade years. From 2003 to 2013 OSI grew revenue at a rate of 15.9% annually when the company was more acquisitive. The healthcare and security businesses were also stronger. The similarity is that it has ebbed and flowed. After sales growth was negative in 2020 and 2021, revenue as a whole has picked up and gained momentum into 2023. Sales were up 8.0% company-wide in 2023 driven by increased sales of the cargo and vehicle inspection systems, contract manufacturing for optoelectronics, and offset by poor growth for healthcare amid tight hospital budgets.

OSI Systems has a global reach with a dedicated direct sales force that is strategically positioned across the Americas, Europe, Middle East, Australia, and Asia, while an extensive network of independent distributors extends the company's reach. Support is robust, with service organizations and authorized providers located in key regions to bolster the sales process and ensure effective after-sales service. The following graphic shows the percent of revenue sourced by region. Revenue from United States has generally made up the majority of revenue but there’s been a slight decline in the past decade with modest increases from United Kingdom and Asia-Pacific.

Revenue generation from abroad had been a cause for concern for OSI, particularly in 2017 when the company was under fire by short seller Muddy Waters who alleged improper sales practices, cash payments to officials and fraud. Muddy Waters said in the report that OSI landed a contract in Albania through corruption and estimated 50% of 2017 EBITDA was from Mexico, despite generating only 15% of its revenue from Mexico through egregious pricing. OSI has been able to shake off those allegations and has even shown itself to be valuable enough to Mexico to land a $500M contract in April 2023 for cargo and vehicle inspection systems to Mexico’s Secretaría de la Defensa Nacional (SEDENA).

The company's research and development efforts are also globally distributed, with design centers in the U.S., U.K., Australia, Singapore, India, and Malaysia, focusing on advancing current product lines and exploring new applications of its technology. OSI notes that most of the labor-intensive manufacturing is done in India, Indonesia, and Malaysia. There’s also manufacturing done domestically in several states from Washington to Massachusetts. Outsourcing plays a role in their strategy, particularly for supplies, accessories, and certain manufacturing requirements like sheet metal fabrication and plastic molding.

Materials and components for OSI's products are a mix of in-house manufacturing and third-party sourcing. Despite strong relationships with single vendors for specific materials, the company maintains alternative sources to mitigate supply chain risks. However, the COVID-19 pandemic imposed challenges, affecting supply chain dynamics, labor availability, and ultimately impacting gross margins and delaying various aspects of service delivery.

Growth strategy: OSI’s growth strategy is focused on leveraging its expertise in cost effective designing and manufacturing of specialized electronic systems for critical applications. The intent is to foster profitable growth within the security, healthcare, and optoelectronics sectors while seeking new markets in which their core expertise would provide a competitive advantage. A cornerstone of OSI's growth strategy is its global reach. With multiple international locations, the company taps into competitive labor rates to reduce manufacturing costs, bolsters its sales and support network, and shortens delivery times to its global customers.

Another strategic asset for OSI is its vertical integration, which streamlines its operations by reducing times and costs, while providing a full suite of services from design to mass production. This not only sets OSI apart from competitors but also adds substantial value for customers seeking comprehensive, integrated solutions.

OSI plans to harness the growing need for advanced screening technologies due to tighter border and cargo controls. The company envisions expanding its reach by offering turnkey security solutions, including the construction and operation of screening checkpoints. Parallel to hardware, OSI anticipates the expansion of SaaS platforms that integrate data from various security sources, leveraging cloud technologies to enable remote management of security operations. Medical technology is another area where OSI is investing, aiming to improve and expand its product range to meet the evolving needs of healthcare providers and patients with user-friendly, reliable, and cost-effective solutions.

Additionally, OSI is not shy about entering new markets that align with its current tech prowess, aiming to extend its footprint through strategic internal growth and acquisitions that complement its existing product lines.

Ultimately, OSI's growth is partly fueled by its commitment to continuously refresh its product suite in response to technological advancements and market demand—a strategy underpinned by savvy R&D and the strategic acquisition of new technologies and companies to lower costs and break into new markets.

Competition: OSI Systems vies for market share with a diverse array of competitors across its varied business segments. In security and inspection, OSI rubs shoulders with industry giants like Smiths Group PLC (SMIN.L), with their Smiths Detection division, and L3Harris Technologies, Inc. (LHX), both known for their advanced security scanning technologies. Pinpointing exact market share figures for top players is challenging due to the diverse product offerings. With that said, according to third-party data, the market for security scanning products was $3.2B in 2022, meaning OSIS made up about 22% of the market, making it one of the strongest players in the industry.

As for patient monitoring, cardiology, and remote monitoring, OSI faces competition from established players like Medtronic PLC (MDT), GE Healthcare (GEHC) and Thermo Fisher Scientific (TMO). These competitors bring to the table a formidable mix of advanced technology and entrenched customer relationships. They also bring to the table quite a bit of scale and resources making it difficult for OSI to compete against.

When it comes to optoelectronic devices, OSI competes with specialized firms like Finisar Corporation (FNSR) and II-VI Incorporated (IIVI), which provide advanced optical components for various applications. OSI's niche is in delivering custom subsystems that require significant engineering expertise, setting them apart from the mass producers of standard optoelectronic components and catering to a specialized segment that values custom solutions over off-the-shelf products.

Overall there’s not perfect peers for OSI to compare against. The mutual peers, according to proxies used for compensation analysis, list Varex Imaging (VREX), Methode Electronics (MEI), Infinera (INFN), Knowles (KN), Viavi Solutions (VIAV), Lumentum (LITE) and Novanta (NOVT). Those companies range in market-cap size between ~$800M and $5.1B, which compares to OSI’s current market-cap of $2.0B. These companies primarily operate in the electronics, photonics, and communication technology sectors. While they share a technological focus with OSI, particularly in areas like optoelectronics and specialized manufacturing, they aren’t as diversified as OSI which includes security and healthcare solutions. These firms are often more specialized in their respective niches.

OSI Systems finds more similarity in Teledyne Technologies (TDY) and Leidos Holdings (LDOS), particularly when considering the breadth of their product offerings. TDY, especially post-acquisition of FLIR Systems (former FLIR), presents a compelling parallel. This merger has broadened TDY's portfolio in advanced imaging and sensor systems, resonating closely with OSI's technological footprint in security and optoelectronics. Similarly, LDOS, with its extensive involvement in defense, intelligence, and healthcare IT, mirrors aspects of OSI's diversified approach, particularly in security and healthcare technologies. Financially, both TDY and LDOS operate at a scale that’s solidly larger OSI and they sport market-caps of ~$18B and $15B, respectively. Notably, they share OSI's blend of serving government and commercial sectors, and their involvement in technology-driven markets makes them apt for a side-by-side financial comparison.

For a short overview of where Leidos Teledyne Technologies generates their revenue, I’ll start with the former. Leidos aligns its operations into three segments: Defense Solutions, Civil, and Health, collectively addressing a range of services and solutions. Their Defense Solutions segment, the largest, made up 57% of total revenues as of 2022, encompassing a broad array of technologically advanced services and products in digital modernization and C4ISR technologies (command, control, computers, communications, Intelligence, surveillance and reconnaissance). The Civil segment contributes a consistent 24%, delivering modernization and security for infrastructure systems domestically and internationally. Health, stable at 19%, focuses on affordable and effective solutions across federal and commercial health missions. The revenue distribution has remained relatively unchanged over the past three years, indicating stable segmental performance.

Teledyne, on the other hand, diversifies its offerings across four segments: Digital Imaging, Instrumentation, Aerospace and Defense Electronics, and Engineered Systems. Their growth is most prominent in the Digital Imaging sector, which has expanded from 32% in 2020 to 57% in 2022, driven by the noted FLIR acquisition. Instrumentation, though decreased to 23% in 2022, still provides a wide array of monitoring and control instruments. Aerospace and Defense Electronics, along with Engineered Systems, represent smaller, yet crucial parts of their portfolio, focusing on electronic components for commercial and defense applications and complex manufacturing solutions for various sectors.

Comparing these profiles to OSI, it's evident that both Leidos and Teledyne, with their segmented structures and focus on defense, civil, and advanced technology systems, share a closer resemblance to OSI’s product and financial spectrum. Unfortunately for OSI the resemblances haven’t transferred to stock performance with a significant lag over the past 10 years. OSI shares have generated a CAGR of 9.6% compared to 15.7% for Leidos and 16.8% for Teledyne.

Capital Allocation: Analysis of capital allocation is a good way to figure out how management has grown free cash flow and understand how efficiently cash flows were spent. OSI can invest back into the business through R&D and CapEx, build through M&A, buyback shares or give back capital through dividends. For this section, I’m going to use Teledyne to compare against OSI in order to provide a measuring stick.

OSI has generated operating cash flow of $1.0B in the 10 years of fiscal 2014 to fiscal 2023. $244M (23.6% of operating cash flow) was reinvested back into the company through capital expenditures. $327.9M (36.0%) was spent on acquisitions, net of divestitures, while $626M (60.5%) was spent on stock buybacks. The biggest year for buybacks was 2022, which proved timely and extended their opportunistic approach of leaning into weakness for buybacks. The 10-year period has seen shares outstanding drop by 16.1%. The largest periods of acquisitions were fiscal 2017 and 2018. In September 2016, OSI spent $266M in total consideration for American Science and Engineering (“AS&E”), a provider of cargo security detection products. The following year OSI bought the explosive trace detection (“ETD”) from Smiths Group for $80.5M. OSI issued a modest amount of stock for AS&E, and the dilution from acquisitions was negligible. Therefore it’s clear the biggest acquisition for OSI has been their own stock.

Teledyne, whose 2022 fiscal calendar ended on January 1, generated $4.25B in cash from operations. $750M (17.6% of operating cash flow) was spent on capital expenditures. However, when you add in R&D (the other form of internal investment), Teledyne’s investment back into the company is quite close to OSI on a relative basis. Where the capital allocation differs is the relative spend on buybacks and M&A. During the 10-year period, Teledyne was only active in repurchasing its shares in 2014 and 2015. The total buyback spend of $390.4M, according to the cash flow statement, is equal to 9.2% of cash from operations (which compares to 60.5% for OSI). The $5.5B in M&A spend at Teledyne is equal to 130.7% of its cash flow from operations (compared to 36.0% for OSI). Two-thirds of the M&A spend at Teledyne was all in 2021 when they purchased FLIR for total consideration of $8.1B. $3.7B was in cash, $3.9B was through the issuance of stock and the remaining $0.5B was through the assumption of debt. All told, the shares outstanding count at Teledyne increased 24.9% from 2012 to 2022 with much of it from the FLIR transaction. I’ll note that even if you remove the acquisition of FLIR, M&A spend would’ve been equal to 43% of the operating cash flow.

Despite OSI’s shares outstanding dropping meaningfully while Teledyne’s increased, the growth in free cash flow per share at OSI is a modest 2.6% CAGR compared to Teledyne’s 10.3%. FCF per share at OSI was $3.74 in 2014 and it increased to $4.72 by fiscal 2023. Teledyne started at a lower base of $3.48 and increased as high as $15.50 in 2021 before regressing to $8.41 in 2022. Excluding Teledyne's 2021 acquisition of FLIR, the two companies exhibit similar capital allocation philosophies. Where Teledyne has excelled is the operational efficiency to increase its profit margins. OSI’s operating margins have roughly been around 10% for the past 10-years. But Teledyne has increased its operating margins to 18% from about 11% over the past 10 years.

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Management and incentives: OSI was founded in 1987 by Deepak Chopra who remains as CEO to this day. That’s a whopping 36 years in the role. Chopra, 72, brought OSI public in 1997 through an IPO and has spent the majority of his career with the company. Before OSI, Chopra did spend time at a few semiconductor companies.

OSI also has a seasoned CFO in Alan Edrick who joined the company in his current role in 1996. Edrick was previously CFO of biotechnology company BioSource International (formerly traded under BIOI) from 2004 to 2006 and North American Scientific from 1998 to 2004.

The third highest ranking executive is Ajay Mehra, 61, who is president of cargo scanning and solutions. Mehra is a first cousin of CEO Chopra and has been with OSI since 1989. He initially held financial roles having joined the company as controller then elevated to CFO from 1992 to 2002 until shifting to operational roles. Before OSI, Mehra was in corporate finance at consumer companies.

OSI has a pay mix that’s made up of salary, annual incentive bonus (often referred to as short-term incentive cash bonus) and long-time incentive pay in the form of performance-based restricted stock units (“RSUs”). Most companies call them PSUs if they vest according to performance, rather than time (which would be RSUs) but OSI calls them RSUs. The percentage breakdown of these is standard for a publicly traded company with CEO Chopra getting 13% of his total pay from salary, 25% from the annual cash bonus and 62% from the stock-based compensation. It’s peculiar and a positive data point that all of the stock-based compensation is in the form of performance-based RSUs, which contrasts with the norm of using a mix of both.

The target size of the annual bonus is 100% for each of the named executives and the max amount is 200% of Chopra’s salary and 150% Edrick. The incentive that decides the payout amount is adjusted return on equity (“ROE”). OSI doesn’t disclose in the proxy what is their difference of adjusted ROE from the standard calculation of net income divided by average shareholder equity. The target amount for 2023 was 22.25%, an increase from 20% in the prior year. As you can see in the table below, there’s been a steady trend of making the hurdle higher for the bonus to be paid in full. Assuming an honest and consistent calculation of adjusted ROE, it’s a good metric for an annual bonus. It also incentivizes management to execute buybacks which brings down the shareholder equity (the denominator in the formula). I’ll note that the two other named executives in 2023 — President, Cargo Ajay Mehra and President, Optoelectronics Manoocher Mansouri — have bonuses tied to the units they oversee.

The largest component of total pay at OSI is the stock-based compensation handed out to executives. As noted, the company gives out stock purely in the form of performance-based RSUs. The incentives for vesting are weighted 20% revenue and 80% EBIT CAGR over a three-year period . Generating a 4.0% CAGR revenue growth rate pays out the revenue component at 100% (which is 20% of the total) and 6% CAGR EBIT growth pays out the profit component at 100% (which is 80% of the total). Management can get additional payouts for generating higher growth. Knowing that the weighting is 80% EBIT growth and 20% revenue growth it isn’t a surprise that profits have grown at a faster clip than revenue over the past decade+.

I find the compensation incentives to be quite strong at OSIS overall. The rise in adjusted ROE threshold, pure use of performance RSUs, and the 20%/80% weighting of revenue and EBIT growth for stock incentives are all positive attributes. My only issue is I’d like to see the compensation committee raise the thresholds for revenue and EBIT growth to incentivize greater growth.

Outlook: There’s a growing need for security in a world that’s increasingly connected economically, which will provide a meaningful tailwind to OSI, particularly for the cargo business that has been driving growth beyond airport security. Airport security, however, gets much more attention. Geopolitical events such as the war in Ukraine and conflicts in the Middle East do generate additional revenue for OSI. This isn’t a geopolitical newsletter so I’m going to refrain from discussing where the world is going, but there’s surely an ongoing need for security products. And there’s even more reason for facilities to revamp security offerings given the improvement in technology that can be applied to threat detection. OSI has previously touted its algorithms for threat detection and image recognition. I expect that to improve further with new AI and machine learning capabilities.

To expand on cargo products more, I’ll dive a little more into the $500M contract with Mexico’s SEDENA ($600M when factoring in taxes). OSI is providing its Eagle P60 cargo inspection systems which is built to fight fraud, drug smuggling, and counter-terrorism. Chopra explained in the April 2023 earnings call after announcing the contract:

“Under this award, we expect to provide multiple units of our Eagle P60 high-energy drive-through cargo and vehicle inspection systems, back care cargo inspection portals, car view vehicle inspection systems and our proprietary CertScan software multisite integration platform. These solutions are planned to be utilized to inspect trucks, buses and cars at customs border checkpoints, increasing the safety and integrity of Mexico's borders. We are honored for our solutions to play a crucial role in facilitating the smooth flow of trade.”

There’s been several other similar smaller contracts for the cargo products with the incentive to the country of improving trade relations. That includes another $200M contract announced in January 2023 to an unnamed international customer and a five-year indefinite contract with an indefinite value in excess of $200M to the U.S. Customs Border and Protection (“CBP”) agency announced in October 2021. Taken together, cargo products have been a critical factor driving growth at OSI.

OSI management most recently gave guidance for 2024 in its October 2023 earnings release for fiscal Q1’24 results. At that time, the expectation for fiscal 2024 revenue growth was 'in excess of 18%', which would represent $1,504M. For context, revenue growth was 3% in 2022 then 8% in 2023. The expected 18% extends momentum with an acceleration in growth. OSI typically gives a standard guidance range but management has opted to give a rough number by saying “in excess” due to the uncertainty of the timing of revenue, including its large contracts, which will also depend on component suppliers. Despite the murky guidance, management says its backlog provides “exceptional visibility”.

OSI’s backlog was at a record high of at $1.8B as of September 30, matching the rough figure given for June 30. OSI’s book-to-bill ratio (orders received verus equipment delivered) has been strong for the past three years and therefore the backlog has been trending higher since the middle of 2020. It’s an additional data point cementing the strong sales momentum.

Despite the large backlog of orders, the sell side analyst estimates aren’t enthusiastic. The average estimate of sales for fiscal 2024 is $1.51B, equal to a 17.9% increase from 2023. For 2025, The average estimate is $1.6B, or 5.9% YoY growth. The 2025 figure implies a material slowdown in growth. However, OSI has strong momentum and their backlog is enough to satisfy above-trend growth for at least two years.

A quick mention on the other two segments, optoelectronics and healthcare. As noted earlier, external revenue generated by optoelectronics comes from a diverse blend of industries and should continue to grow at a rate in-line with the economy. OSI has done a good job winning additional business through contract manufacturing which can continue to grow at a rate slightly higher than American GDP for the foreseeable future. Management has touted high reinvestment rates for the healthcare business and a shift to a subscription service. I’m not enthusiastic about OSI’s healthcare business but it is a shrinking piece of the pie and is becoming immaterial.

Valuation: I put together a discounted cash flow model by forecasting revenue and margins, for the next five years. The healthcare and optoelectronics segments are expected to grow steadily at ~2% and 5%, respectively, over the next five years. Those figures generally match the growth rates over the past decade. The security business shows a significant ramp-up in sales in 2024 and into 2025, then tapers to 5% growth in fiscal 2028. Recall CAGR growth rate of the security segment is 7.4% over the past decade.

The model also forecasts a gradual, modest increase in EBITDA margins. There’s a few reasons for this starting with the fact that the security segment has better margins than the other two segments and by 2028 OSI could be generating 78% of its revenue from the security segment. Over the last 10 years, the EBITDA for the security segment averaged 18.8% (closer to 15% when you attach some corporate costs to the sector) so a company-wide EBITDA margin of 15.0% seems reasonable. Moreover, the security segment could be shifting toward more turn-key contracts where OSI supports the customer by operating the hardware, in addition to selling the hardware. Two more reasons that support the forecast of higher margins are higher operating leverage as OSI continues to grow and a potential shift to leasing and selling more software services.

Some simple assumptions to calculate free cash flow are as follows: CapEx at about 1.6% of revenue per year, depreciation and amortization at 3.8% of revenue and a pro-forma tax rate of 22%. The other critical assumptions are the cost of capital of 7.6%, which is based on OSI’s beta of 0.97, and current five year risk free rate of 4.0%. Together, this calculates a fair value of about $185, which implies 42% upside in the stock price.

Most of these deep dives use an EBITDA exit multiple, but for OSI I opted for a perpetuity exit using a terminal growth rate of 3%. The terminal value would be equal to 14X EBITDA (LTM). OSI has traded more closely to 11X so that level is slightly high. However, I built a peer list for OSI of stocks mentioned in the competitor section and several others in the industry of similar size. The median 5 year CAGR for revenue for the peer list is 5% and the EV/EBITDA (LTM) is 14.1X. Having said that, I understand why OSI trades at a discount. Their revenue has fluctuated a lot more than their peers and no investor wants to ride a roller coaster.

Final Thoughts: OSI, led by the security segment, has strong momentum right now and it’s making for an undervalued stock. I will stamp shares with an outperform/buy rating. I do note there could be turbulence in the financials in the next year as OSI ramps up sales to meet its larger contracts. This could be supply chain oriented or customers who aren’t ready to accept orders just yet. Regardless, with a long-term view, OSI appears to have a good margin of safety with the calculated $185 fair value via the DCF model.

Another point of interest for investors should be the succession plan for CEO Deepak Chopra. At 72, Chopra will likely need to hand over the reins in the near to medium term. EVP Ajay Mehra, who has effectively overseen the high-performing cargo business, might not be the ideal successor due to concerns about optics. With Chopra leading OSI for 36 years, a transition of leadership for this $2+ billion company should be thoughtfully executed. Rather than an easy handover to Chopra’s cousin, Ajay Mehra, a broader strategic initiative might be more fitting. This could involve divesting the healthcare business to streamline OSI, or potentially pursuing a transformative acquisition or reverse Morris trust spinoff to rejuvenate the management team. Additionally, there's uncertainty regarding how a potential return to the presidency by Donald Trump could impact OSI. While his administration might favor border security, his stance against globalization and trade could lead South American countries to reassess investments in cargo security aimed at boosting trade. I’ll continue to monitor OSI and am eager to see how the company navigates this new growth cycle in 2024.

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Disclaimer: The content of this report is for informational and research purposes only and should not be construed as financial advice. The views expressed are my own and do not reflect those of my employer. While care has been taken in preparing this report, I make no representations or warranties of any kind regarding its accuracy or completeness. I currently hold no position in any stock mentioned. However, like any financial analyst, my perspectives may carry inherent biases. Readers are encouraged to conduct their own due diligence.

There’s a growing trend to retrofit older structures to make them more energy and water-efficient. That’s likely to be further fueled by legislative mandates for filtered water. Zurn Elkay rides this wave with a broad product portfolio, securing their position as industry frontrunners by crafting innovative solutions compliant with rigorous third-party regulatory, building, and plumbing code prerequisites. Their distinctiveness in the market is rooted in a rich lineage of innovation. As a result, ~75% of their revenue comes from products Zurn Elkay is a market leader. With an increasing public awareness of quality drinking water, and a willingness for law makers to make clean water mandates more stringent, there’s a meaningful tailwind for Zurn Elkay going forward from increased demand for its products.

The investment thesis for Zurn Elkay comes down to a growing awareness and legislation for stricter water quality testing and filtering. The consensus growth estimates for Zurn Elkay are modest and I discuss later in this post that Zurn Elkay can beat those estimates by growing at the historical rate. Despite that, there’s only modest upside of ~20% in the stock according to my valuation estimate of $31.34 via a DCF model.

The rest of this post will cover Zurn Elkay Water Solutions by providing an overview of the business and the industry dynamics followed by an examination of the capital allocation history, management and their incentives, capped with an outlook and valuation.

In order to become a pure play water company, Zurn Elkay has transformed quite a bit in the past two years. Zurn Elkay’s predecessor company was previously known as Rexnord (former ticker RXN), which previously operated the water management segment and a process and motion control (“PMC”) segment making mechanical components for complex systems. Rexnord spun off the PMC segment in October 2021 and merged it with then Regal Boloit in a reverse-morris trust (“RMT”) style spinoff. RMTs are used for companies that spinoff a segment and immediately merge it with another business. Regal Boliot changed its name to Regal Rexnord (new ticker RRX) while former Rexnord changed its name to Zurn Water. But the transformation didn’t stop there. In February 2022, Zurn Water announced the acquisition of Elkay Manufacturing for approximately $1.56B bringing on leading water products serving the commercial market. Zurn Water then changed its name to Zurn Elkay Water Solutions with previous Zurn Water shareholders owning 71% of the combined company and the Elkay shareholders, which constituted the original founding family, owning the remaining 29%.

With a broadened portfolio boasting prominent names like Zurn, Elkay, and Wilkins, their products find their presence spanning across a diverse spectrum of end-use scenarios. Water safety and control products, under Zurn and Wilkins, provide solutions like backflow preventers and pressure-reducing valves, and find applications across commercial, residential, and institutional spaces to control potable water supply. On the other hand, flow system products manage storm and wastewater through diverse offerings, from point drains and hydrants to innovative wastewater pre-treatment products, marketed under brands like Zurn and Green Turtle that help the environment and safety of wastewater discharge. Navigating towards the hygienic and environmental product line, Zurn Elkay encapsulates a vast domain from sensor-operated flush valves, commercial faucets to water conserving fixtures, articulated through brands like Aquaflush and EcoVantage as solutions across institutional and commercial spaces. Next time you walk into the bathroom of a modern office or other commercial facilities like airports there’s a good chance the toilet, sink or faucet was made under the Zurn Elkay umbrella. Strategic acquisitions such as Just Manufacturing and Hadrian have further augmented the breadth of offerings in the hygienic and environmental domain. The merger with Elkay has notably broadened horizons into the drinking water product segment, which caters to diverse applications by offering a wide array of drinking water solutions, ensuring a blend of hygiene, accessibility, and sustainability. In general, Zurn Elkay avoids segments of the market that are commoditized or don’t require differentiation.

Zooming out, the markets Zurn Elkay operates in are vast and fragmented, but they've carved out their niche. Their focus areas are tethered to the growth in commercial, institutional (education, healthcare and government segments), and waterworks construction. They've anchored their business around markets with long-term growth potential, wherein they either lead or see a clear pathway to leadership. When the merger with Elkay was announced in 2022, the presentation at the time pointed out that 75% of the combined revenue comes from end-markets Zurn Elkay is the #1 leader in and 95% come from products that are either #1 or #2. What I find most iconic is Elkay’s drinking fountains and water bottle filling stations.

Moving to product development, an approximate team of 150 engineers leverages a "Voice of the Customer" philosophy. Zurn’s product development team got a boost by acquiring Elkay with a combined team of 150 engineers (up 67% from the prior year). The expansion will help expand innovation for the company. A notable area of innovation for Zurn Elkay has been in IoT where the company has been spending time adding digital features for wireless monitoring of water usage and consumption, and alerting of efficiency for maintenance purposes. As more states mandate monitoring of water quality, it’ll be an important feature. There’s a nice section in the 10-K covering the company philosophy through Zurn Elkay Business Solutions (“ZEBS”) that states:

a culture that embraces Kaizen, the Japanese philosophy of continuous improvement and the concepts around 80/20 simplification. We believe applying ZEBS can yield superior growth, quality, delivery and operating costs relative to our competition, resulting in enhanced profitability and ultimately the creation of stockholder value. As we have applied ZEBS over the past several years, we have experienced improvements in growth, productivity, cost reduction and asset efficiency and believe there are opportunities to continue to improve our performance as we continue to apply ZEBS.

Competition: When it comes to the competitive landscape, Zurn Elkay is short on words in describing its competition. Using inFilings structured filings, I ran a search of industrial companies above $100M in market-cap and found that 90% of companies have a full sub-section within business description dedicated to explaining their competition. It’s the norm for companies to dedicate a section to talk about competition, which is an insightful portion of the 10-K that satisfies regulatory expectations of transparency. In addition to a boilerplate risk factor on competition, Zurn Elkay simply has this written in the 10-K:

“The markets in which we participate are relatively fragmented with competitors across a broad range of industries, sectors, and product lines. Although competition exists across all of our businesses, we do not believe that any one competitor directly competes with us across the breadth of all of our product lines.”

To get an idea of some competitors, they would be Watts Water Technologies (WTS), Badger Meter (BMI), Circor (CIR), Kohler (privately held), American Standards Brands (owned by Japanese LIXIL Group), Sloan Valve (private), Moen owned by Fortune Brands (FBIN) and German-listed Gerberit (SIX: GEBN). Mutual peers within the proxy last year were BMI, CIR and MWA, which means those companies also listed Zurn Elkay as a peer.

While Zurn Elkay delivers an expansive portfolio that blankets both aesthetic, user-interactive products such as sinks and faucets and critical, behind-the-scenes infrastructure components like flow management systems, its competitors exhibit more specialized focuses. For instance, Kohler and Moen predominantly spotlight their consumer-facing, visually appreciable products like faucets and sinks, aligning their brands strongly with the aesthetic and functional aspects of water usage in both residential and commercial spaces. Conversely, a company like Badger Meter pivots sharply toward the unseen, foundational aspects of water management, concentrating on flow measurement and control technologies which, while crucial, do not engage the end-user in a direct, visible manner. Thus, Zurn Elkay uniquely straddles two facets of the industry: marrying the visible, interactive aspects of water use with the unseen, vital components that ensure its safe and efficient delivery and management

I’ll discuss and compare products by Watts Water and Zurn Elkay a bit more. Watts Water and Zurn Elkay share commonalities in their product offerings, especially within the domain of water safety, control, and management, establishing them as competitors in certain market segments. Both companies offer products that ensure safe and efficient water flow and management within various building and construction contexts, underscoring the crucial aspect of safeguarding potable and emergency water supplies. For instance, both firms manufacture backflow preventers and thermostatic mixing valves, which are necessary for preventing water contamination and ensuring safe water temperature, respectively. Moreover, both companies exhibit a strong focus on water quality and drainage solutions, an example being Watts Water's drainage & water re-use products and Zurn Elkay's flow systems products, which manage storm water and wastewater through various products and systems like point drains and linear drainage systems.

However, while there's noticeable overlap in certain product lines and solutions, Watts Water and Zurn Elkay also exhibit unique offerings and strategic focuses that differentiate them within the market. Zurn Elkay, particularly after the Elkay merger, has solidified its standing in drinking water products. In contrast, Watts Water delineates a substantive involvement in the HVAC & gas product domain, which includes commercial high-efficiency boilers, water heaters, and hydronic pump groups, areas which Zurn Elkay doesn’t appear to have an emphasis on.

Segment Analysis: Currently, Zurn Elkay reports revenue for “institutional” customers, “commercial” customers and “all other” (residential and waterworks) as three different buckets. “The institutional construction end users include education, healthcare, and government segments. The commercial construction end users includes office, warehouse, lodging, retail, dining, and sports arenas segments,” according to the latest 10-K. Institutional customers made up 40% of company-wide sales in 2022, with each commercial and “other” pulling in about 30% of sales apiece. Institutional was up slightly from 2021 while commercial and other made up slightly smaller pieces of the pie.

Before the spinoff of Rexnord’s Process & Motion Control segment, the combined company reported the Water Management business as a different segment and also broke out operating profit separately. At the time, the water segment was further detailed by sales of 1) Water safety, quality, flow control and conservation products and 2) Water infrastructure. The spinoff was completed at the start of Q4’21, so company-wide sales have only been the pure play water segment for the past seven quarters. That short period isn’t enough to judge a company making it important to reach further and grab financial data for the water segment of the previously combined Rexnord company.

The following chart plots out Zurn Elkay revenue by year since the start of 2016 and shows the year-over-year (“YoY”) change as reported and the percent change in core sales YoY. Core sales represent the organic change by removing mergers & acquisitions, divestitures and foreign currency impacts. Reported sales were up 40.7% in 2022 via the acquisition of Elkay while core sales were up 11% that year, according to Zurn Elkay. Sales were particularly strong in 2021 and 2022 and increased at an annual rate of 6.7% from 2015 to 2022. Meanwhile, Elkay grew revenue at an annual rate of 12% in the 10-years leading up to the merger in 2022.

To get a more detailed understanding of their growth history, here’s a look at sales and core growth on a quarterly basis. Before Q4’22, the only period there was negative organic growth was from calendar Q3’16 to Q1’17 when it ranged from -4% to -1%. Part of that decline was driven by underperforming wastewater assets. Two years later, in 2018, management decided to sell the VAG business (wastewater products) and stopped reporting it in calendar Q2’18, hence the drop in reported sales while core sales was up 9% in calendar 2018.

More recently core sales turned negative again in Q4’22. That quarter Zurn Elkay blamed lower residential market demand and “channel partners reducing inventory levels following the overall improvement of our lead times.” Core sales reversed back to positive in Q1’23, but negative again in Q2’23. Inventory has more recently normalized but the negative -5% core growth in Q2’23 was attributed to soft residential demand “as well as timing of shipments in the prior year as we began working down an elevated backlog during the second quarter of 2022.” What I also found notable is that Zurn Elkay said the core sales figure would be -1% on a pro forma basis when excluding product lines that management opted to exit. During the October 2022 earnings call CFO Mark Peterson said:

“Over the past 90 days, we've been able to thoroughly review the Elkay sales volume at a SKU level and customer level and have finalized the plan and simplify the business to focus on better growth, better margins, and better returns on invested capital.”

Peterson added during the February 2023 earnings call:

"With respect to residential sinks, we continue to execute on our 80/20 simplification actions in the quarter to exit certain residential commodity, private label and OEM sink SKUs and remain on track to our targeted SKU reduction and related profitability improvement.”

It’s nice to see Zurn Elkay management spot underperforming businesses or product lines that don’t fit the strategy and quickly opt to sell/discontinue.

Now shifting to profitability. Just like the quarterly sales data, I grabbed the quarterly operating profit and EBITDA figures for the water segment pre-spinoff and then used company-wide profit measures post-spinoff. Those are summed for annual figures and presented below. I’d like to bring up an accounting note about segment analysis. When companies report segment profit, they generally associate costs to each segment, and have costs that don’t go into a segment that instead are listed under “Corporate”. Therefore, segment margins are inflated, which is something to be aware of when looking at the water segment profit margin pre-spinoff. Here’s an example to make that clear. During fiscal 2019, Process & Motion Control had $1,380.6M in sales and operating profit of $226.1M, resulting in a margin of 16.4%. Water segment had $670.3M in revenue (32.7% of total revenue) and had $139.7M operating profit, or an operating profit margin of 25.7%. Corporate reported an operating loss of $60.2, which netted company-wide income from operations to $305.6M (14.9% company-wide operating margin).

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Zurn Elkay’s water segment has routinely been profitable when looking at operating margins or EBITDA margins. From 2016 to 2020, profit margins crept higher, culminating in an EBITDA margin of 26.4%. Margins regressed in 2021 as costs outpaced sales during supply chains issues post-COVID. In all cases, margins in the graphic below are non-adjusted, which amplifies the drop in margins in 2022 because of the one-time costs brought on that year by the acquisition of Elkay. Reported EBITDA for 2022 totaled $161.6M (12.6% EBITDA margin). That amount includes $68M in costs that are one-time in nature, particularly restructuring costs, fair value adjustments for acquisitions and merger costs. Absent that amount, EBITDA would’ve been $229.6M (17.9%). Point being, low margins seen in 2022 were abnormal and the business performed better than as reported.

Longer-term, the merger with Elkay provides an opportunity for profit margins to rebound back toward the 2020 peak. When management announced the merger early in 2022, they said there was a target of $50M in synergies that would add to the bottom line. Zurn Elkay is on schedule for that cost-reduction plan, according to commentary on the latest earnings call. CEO Todd Adams:

“when we announced the transaction a year ago, we outlined $50 million. We obviously got a running start over the back half of last year. We got $25 million plus this year, and we're targeting another $25 million. So in aggregate, it will probably end up being a little bit more than the $50 million that we originally contemplated, but it's essentially on the same timeline.

I think the only acceleration was some of the simplification work that we did really from July through December because we just felt like getting that piece behind us quicker, sooner would aid everything else, whether that was supply chain, whether that was organization, whatever it might be, we sort of got ahead of it early but since then, we've been hitting our marks on whether it be an announcement or internal work that needed to get done to facilitate a next set of moves. So very much on track, taken as a whole probably a little bit ahead early the last 6 months of last year.”

As an example of the functional efficiency being tackled, Zurn Elkay has consolidated manufacturing of similar products. And to frame the $50M in cost savings, that’s roughly 3% of sales, or enough to place Zurn Elkay’s EBITDA margin at around 24% - 25%.

Capital Allocation: Analysis of capital allocation is a good way to figure out how management has spent capital and how efficient they’ve been. For an industrial company like Zurn Elkay, they can invest organically through capital expenditures, expand through M&A, or return capital through stock buybacks or dividends. For this section I’m going to look back at the last 10 years of financial data to understand management’s philosophy. A big portion of the capital generated was through the now spun-off Process & Motion Control segment. However, I’m more focused on management actions here so it’s more relevant to include the company as a whole. Also note that I’m relying on Koyfin financial data for this section, unlike the segment analysis that was gathered manually.

Zurn Elkay has generated a cumulative $2.1B in cash from operations since 2013. $425.6M was spent on capital expenditures (20.3% of cash from operations), $211.3M was spent on stock buybacks (10.1% of cash from operations) and $146.9M (7.0%) was spent on dividends. In addition, $824.9M (39.3% was spent on acquisitions, net of divestitures). Note that their total spend on acquisitions of $824.9M is well below the single acquisition of Elkay that was for $1,462.9M. That acquisition was paid for in stock and you can see from the table below that shares outstanding ballooned by ~40% after it closed. Prior to that, its large acquisitions consisted of $213.7M for Cambridge into the Process & Motion Control segment in fiscal 2017 and another $173.6M spent on World Dryer and Centa in fiscal 2018. World Dryer, a maker of hand dryers, sat within the water segment. All three of those acquisitions were paid for in cash. However, Zurn Elkay did issue nearly $400M in convertible stock at the time that converted to 16.0M shares in 2020, another bump in the shares outstanding count. In total, the shares outstanding is 82% higher than it was in 2013.

It’s helpful to get a comparison of capital allocation so for this section I gathered similar data for peer Watts Water. Since 2013, Watts Water generated $1.65B in cash from operations (“CFO”). The company spent $308.2M on CapEx, equal to 18.6% of CFO. $416.3M (25.2%) was spent on M&A, $361.6M on stock buybacks (21.9%) and lastly $276.6M (16.7%) was spent on dividends. It’s a more balanced approach to capital allocation than Zurn Elkay who has returned a small amount to shareholders via buybacks and dividends, and instead spent more on M&A. What’s also notable is each company spent less than they generated through cash from operations and therefore the net debt (debt after subtracting cash) went down for both companies. It was popular for companies to raise debt and spend more than they made over the past decade during an era of low interest rates but these two companies stand in contrast to that philosophy.

I also want to draw attention to the growth in FCF per share, one of the best financial performance metrics. After the acquisition of Elkay in 2022, free cash flow per share took a hit in 2022 by dropping to 51 cents per share. Recall margins were depressed due to merger costs and the shares outstanding jumped higher. Considering Zurn Elkay (its predecessor company) generated FCF of 87 cents per share in 2013, the growth turned out to be negative through 2022. Assuming Zurn generates $215M in FCF in 2023 (current estimate), that still makes for no growth in FCF over an 11 year period that’s seen quite a bit of dilution.

Watts Water, on the other hand, has steadily grown its FCF per share since 2023 with a compounded annual growth rate (“CAGR”) of 9.7%. It’s paid off for Watts Water with shares growing at an annual rate of 15.2% compared to Zurn Elkay whose shares generated a 9.5% annual return.

Management and Incentives: Zurn Elkay has been led by Todd Adams as CEO since 2009. Adams has a financial background having joined Zurn Eklay (then Rexnord) in 2004 as treasurer and controller and then served as CFO for a year then took on a brief operating role as president of the Water Management platform before taking the helm as CEO. Before Zurn Elkay, he held senior financial positions at Boeing (BA), APW Limited and Idex Corp. Also note that Adams is on the board of Badger Meter, a peer of Zurn Elkay with some product overlap.

Mark Peterson joined Zurn Elkay in 2006 as a unit CFO. He then was promoted to corporate vice president & controller and in 2011 was elevated to his current role as CFO. Peterson has overseen the financial transformation of Zurn Elkay. Initially as the company transitioned from a private equity ownership from Apollo to the public markets through a March 2012 IPO. Next through the spinoff and subsequent acquisition of Elkay.

The second highest-ranked executive, according to compensation, is chief operating officer Craig Wehr. Wehr was promoted to his current role as COO in August 2022 after serving as president of Zurn. The promotion made it so Wehr is responsible for company-wide operations that now include Elkay. Wehr joined Zurn Elkay in 1993 as a regional sales manager and worked in increasing roles by adding sales and business development responsibilities.

Zurn Elkay has a balanced compensation incentive program, starting with healthy salaries and cash bonus. The table below extracts data from the 2023 proxy listing summary compensation figures for the top four currently employed executives. The pie charts below show the breakdown by type of pay when aggregating over the previous three years. CEO Todd Adams has had 12% of his compensation paid in the form of a base salary, 21% from an annual cash bonus and 64% came from stock-based compensation. I bucketed CFO Mark Peterson and COO Craig Wehr as other Named Executive Officers (“NEOs”). Those two averaged 18% of total compensation from salary, 17% from their annual cash bonus and 62% from stock-based compensation. It’s normal for non-CEO NEOs to get a little more pay from salary as a percent compared to CEOs but executives at Zurn Elkay are fairly even. Before moving on to the actual performance drivers of the compensation program, note the variation in stock award values by year. For instance, CEO Todd Adams was paid $4.2M worth in 2020, then $11.9M in 2021 and nothing in 2022. That’s because Zurn Elkay paid the 2022 annual award in October 2021 (instead of annually in May) to get ahead of the spinoff so 2021 was doubled-up in value.

Let’s dig into the actual performance drivers of the compensation plan to understand how top executives are incentivized. Starting with the short-term cash bonus. Payout of the cash bonus at Zurn Elkay is weighted 50% adjusted EBITDA and 50% free cash flow. Both metrics are heavily doctored. Adjusted EBITDA nearly matches what the company reports in earnings for adjusted EBITDA, except they use constant currency for the compensation program. And Free cash flow also subtracts several costs, such as un-budgeted acquisition costs, tax benefits on stock option exercises and “other non-recurring items”.

The value of the cash bonus is determined based on financial success against pre-set annual goals. Targets are a percent of the salary (125% of the salary for Adams, 50% to 100% of the salary for other executives). Meeting the financial goals means 100% of the target is paid; anything less than 90% of the financial target is not paid and executives can get 250% of the target amount for exceptional financial performance.

Zurn Elkay made $140M in free cash flow in 2022, according to the calculations for the purposes of the compensation program, which was 90% of the goal. Adjusted EBITDA was below the minimum and paid out at 0%. I’ll note that Zurn Elkay didn’t actually say what the adjusted EBITDA goal was which I’d view as poor corporate governance.

The largest component of compensation for executives at Zurn Elkay, and most public companies, is through long-term equity incentive awards, known as stock-based compensation. For 2023, 40% of the value of stock was in the form of restricted stock units (“RSUs”) which means they vest out over time regardless performance. The remaining 60% is paid in the form of performance stock units (“PSUs”). That’s the same ratio as the prior year, though some executives have been paid a mix of options and RSUs instead of PSUs. PSUs can be earned at a level between 0% and 200% based on performance during a three year period. The actual incentives are free cash flow conversion and ROIC. The reasoning is below, from the 2020 proxy:

Vesting of 50% of the value of the fiscal 2020 PSUs is based on goals related to absolute free cash flow conversion (defined as free cash flow divided by net income before special items) to reward the efficient generation and use of cash, which also aligns with the Company's long-term strategic plan. Vesting of the other 50% of the value of the fiscal 2020 PSUs is based on goals related to return on invested capital ("ROIC"). The Committee uses ROIC as a performance measure for the fiscal 2020 PSUs to help ensure that our executives focus on effectively employing capital and creating stockholder value as well as to better align with the Company's current growth strategy and absolute free cash flow conversion goals.

The last published goal was simply turning 100% of the net income into free cash flow. And the ROIC goal was 11.75%. Similar to the cash bonus disclosures, Zurn Elkay hasn’t always been clear on the goals (what the actual ROIC target is for instance).

Zurn Elkay's decision to use both metrics of FCF conversion and ROIC indicates a desire to balance efficiency (free cash flow conversion) with effective capital use (ROIC). However, the combination is strange. While both metrics are geared towards efficiency, neither directly incentivizes overall growth or absolute profitability. In a scenario where the company's net income is dwindling, even a 100% free cash flow conversion might not be impressive in absolute terms.

Outlook: Before looking ahead, a reminder on past growth rates. Zurn’s water segment within Rexnord grew at an annual rate of 6.7% from 2015 to 2022 (pre-Elkay merger). Elkay, according to Zurn management, grew at an annual rate of 12% in the prior decade to the merger. The Elkay side skews more toward drinking water, even though there is non-drinking water products such as sinks and faucets.

There’s a growing awareness of a need for filtered water and more states are mandating filtered drinking water. To be clear, The Safe Drinking Water Act (“SDWA”) was passed in 1974, mandating quality drinking water for human consumption. It served as a foundation for clean water and has been amended in the decades after, but states have more recently pushed for higher standards. In the February earnings call for Q4’22 results, CEO Adams referred to the following slide and said:

In this 3-year plan, we're over-indexing our strategy deployment process around drinking water, actually safe drinking water, focused on K through 12 students and schools, which we believe is worth hundreds of millions of dollars of growth moving forward as the states and legislation are now beginning to take meaningful action to solve the issue…

The reality is in this country, over half the population drink water from lead service lines, the most vulnerable are kids with the impact felt not only in places that you've heard of like Flint, but very, very likely in the schools where you live, your kids, your neighbors, nieces, nephews or grandchildren go to school. With over 131,000 K through 12 schools in the U.S., over 13 million kids went to school last year with elevated lead levels. There is, however, a growing awareness and legislation that's beginning to take shape, and we're investing to make sure that we have the go-to solution to address this incredibly solvable problem. It starts with having a leading market share and largest installed base of point-of-use drinking water solutions in Elkay.

Continuing on this theme of growing awareness and legislative action, Michigan recently took a significant step in this direction. Governor Gretchen Whitmer signed a set of bipartisan bills collectively known as the "Filter First Bills" on October 19, 2023. These bills, encompassing House Bills 4341-4342 and Senate Bill 88, mandate childcare centers and schools in the state to install water filters to thwart lead contamination. Beyond the mere installation of filters, the Clean Drinking Water Act that these bills enact requires institutions to develop comprehensive drinking water management plans. It's not just about putting up a filter and walking away. Institutions are required to engage in routine sampling and testing to ensure the young ones are indeed sipping from a safe source.

This legislative move is emblematic of a broader trend. While the SDWA laid the groundwork for water quality standards nearly half a century ago, states like Michigan are pushing the envelope, demanding more stringent standards tailored to contemporary challenges. The crux of Michigan's bills is a response to a stark reality – the lasting and detrimental impact of lead exposure, particularly on children. With memories of the Flint water crisis still fresh, Michigan is pioneering efforts to ensure such a catastrophe doesn't befall another community.

The stricter requirements imply that schools and childcare centers will be looking for robust, reliable solutions to meet these mandates. Companies poised with the right products, expertise, and market presence such as Zurn Elkay stand to gain significantly. As CEO Adams pointed out, with over half the U.S. population drinking water from lead service lines, and many of them being children, the need is urgent, the problem solvable, and the market vast. In that same February earnings call, Zurn Elkay listed out a long-term total addressable market (“TAM”) of $2.9B, which assumes a government willingness to pay for 130K schoools to re-vamp their drinking water, and hundreds of millions in annual revenue in just a few years out. In addition, there’s a recurring revenue aspect with a replacement cycle of 3-5 years for fountains and bottle fillers. The Michigan legislation might just be the tip of the iceberg, setting a precedent for other states to follow suit. If the trend of more filtered water continues, we can anticipate a surge in demand for drinking water solutions, presenting companies like Zurn Elkay with a lucrative growth trajectory.

As bullish as that sounds, it doesn’t appear the market is forecasting high growth rates, at least judging by sell-side analyst estimates. The consensus estimate for 2024 implies a 2.1% growth rate in revenue and 4.8% growth rate in 2025. Margins are expected to improve by 250 basis points through 2025.

Valuation: I put together a DCF model by forecasting financial performance over the next five years. Zurn Elkay doesn’t have defined segments to break out revenue. The disaggregation by customer type is somewhat new therefore this DCF just includes consolidated financials.

The DCF starts with revenue of $1,538M in 2023 which essentially matches the management guidance for the year. After that, I’m estimating growth of 4.0% in 2024 then 6.5% and 7.5% in the final two years. Note that this trajectory is solidly higher than the street estimate and roughly in line with the growth rate of Zurn Elkay as a combined company. In July, Zurn Elkay management issued adjusted EBITDA guidance for 2023 of $340M, which would translate into about $290M in unadjusted EBITDA. However, there’s still some one-time costs this year that will bring EBITDA down to my estimate of $277M/18.0%. Margins should be on a good track to recover back to 24.0% by 2026, if not sooner.

Some simple assumptions to calculate free cash flow are as follows: CapEx at about 2.1% of revenue per year, depreciation and amortization at 5.8% of revenue and a pro-forma tax rate of 22%. The other critical assumptions are the cost of capital of 9.0%, which is based on Zurn Elkay’s beta of 1.1, and the exit multiple of 15 times the LTV EV/EBITDA. The two combine to produce a fair value of $31.34, which implies upside of 22.4%.

No reader has an issue seeing a 9% cost of capital. The exit multiple, on the other hand, is what brings out differing opinions. Industrial companies trade with valuation multiples that vary quite a bit, with ESG-type companies often fetching premiums. Take Zurn Elkay for example. After Rexnord announced the separation of the non-water segment in February 2021, the company has traded at a higher valuation multiple. The chart below from Koyfin bounced around as EBITDA also bounced around because of one-time costs.

In order to get a better sense of the market, I built a peer list of companies by extracting similar-sized non-utilities companies from two thematic ETFs: Global X Clean Waters (AQUA) and Ecofin Global Water ESG Fund (EBLU). These companies have a similar growth profiles of Zurn Elkay with a 5-year CAGR of ~8% and a current average EV/EBITDA multiple of 20X with the median at 13.3X. Given my forecast of growth of 7.5% in five years, an exit multiple of 15X EV/EBITDA seems quite fair.

Conclusion: The potentially strong clean-water tailwinds make Zurn Elkay a company worth tracking. The fair value estimate of ~$31.00 doesn’t provide enough margin of safety to make me want to buy shares right now. Zurn Elkay is an interesting enough company to continue to monitor. As I post this write-up while traveling to San Diego, clean water is a topic that’s been on my mind more. During my due diligence phase I found that San Diego tested poorly for drinking water, as compared to other parts of California. I’ve enjoyed seeing Zurn Elkay products begin to help that through filtration. A couple data points I’ll watch for are legislative changes and cost efficiencies that can yield better free cash flow. Zurn Elkay has room for more buybacks in order to decrease the shares outstanding. Most of their peers carry very little debt and in order to fit in there’s not much capacity for leverage. Therefore, increasing FCF per share will come down to better profitability and growth.

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Disclaimer: This is not advice to buy, sell or hold any stock referenced. Do your own due diligence. I have no position in any stock mentioned in this report. Like any financial analyst, doesn’t mean I’m not biased.

Overview: Synaptics is a tech company founded in 1986, specializing in creating the "brains" behind various smart devices. The company stands as a major developer and fabless supplier of mixed signal semiconductor solutions, which refers to complex chips that help devices like smartphones, laptops, and cars understand both digital and analog signals—think of these as interpreters between the device and its user. The company serves three main markets: Internet of Things (IoT) 70% of revenue, Personal Computers (PC) 16% of revenue, and Mobile devices 14% of revenue (those percentages have evolved quite a bit in its history.) Taken together, their current product is on consumer technology products. The company has had three distinct phases in which they first focused on PC products, then shifted to mobile and now IoT.

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PC Product Applications: Synaptics develops features for PCs like touchpads and fingerprint sensors for enhanced security and ease of use. In its earliest days, Synaptics is credited with creating the world’s first touchpad for laptops and they still have a strong hold on the market for touchpads. If you’re reading this on a laptop, there’s a strong chance Synaptics built the touchpad for your computer. They’re also the leading maker of fingerprint sensors on computers.

Mobile Product Applications: On the mobile front, Synaptics supplies technologies for smartphones and tablets. Their focus here is on user-friendly designs that are efficient, durable, and reliable.

Synaptics aims to solidify its leading role in the semiconductor market, specifically targeting IoT, personal computing, and mobile applications. The company plans to innovate by leveraging its extensive intellectual property and engineering expertise to produce user-friendly, cost-effective products. Their focus is on the fast growing IoT sub-sector, where Synaptics wants to expand by adapting its technologies to meet market demands. Strategic partnerships and acquisitions are also on the agenda to diversify offerings and penetrate new markets. Additionally, the company employs a 'fabless' manufacturing model, outsourcing production to focus on R&D, thereby keeping costs flexible and tied to sales. Overall, Synaptics is gunning for market expansion through technological innovation and strategic collaborations.

Synaptics offers a diverse range of products aimed at providing interface solutions across various consumer and industrial segments. They’re often a market leader for the products they make (see graphic above) which are niche. It’s a theme CEO Michael Hurlston talked about in the recent September 6 Investor Day.

If you look at our IoT portfolio today, we have a lot of products that are in relatively narrow segments, I'd say but are #1 or #2 in those various markets. Our challenge as a company and what we've been aiming to solve is, how do we get into bigger markets? If you think about it today, we are in a series of markets. These are all great markets for us. All of them are narrow.

They're not huge in terms of the TAM or the SAM that we can go after, and we're a significant player in all of these markets. So we want to take the success that we've had here in these narrower markets and build into broader markets where there's larger opportunity for us and that again, will lead to this concept of growth.

To make sense of their other products, in high performance, they make chips for over-the-top streaming, home security, robotics and drones. Winning business for these types of products comes down to long range, low power consumption and size. Synaptics says they win in all three of those. Broad market applications feature (smart) appliances, home automation and sensors, and wearables (watches/fitness trackers). These are propelled by wireless connectivity with state-of-the-art Wi-Fi, Bluetooth, and GPS solutions. It’s important to note that Synaptics isn’t just making computer chips for technology products to communicate with each other, but also creating software for the products. In the August 2023 earnings call, CEO Hurlston discussed product developments and pointed out the use of its Active Noise Cancelling (“ANI”) and Environmental Noise Cancelling (“ENC”) software.

On the product front, we've started a journey to expand our existing processor portfolio into more deeply-embedded applications. We have a few design wins now in this area, leveraging both existing software and hardware, differentiating with our AI capabilities. With limited investment, we believe we can unlock opportunities outside our traditional operator space in applications such as video conferencing, high-end smart appliances, point-of-sale terminals, factory automation and security solutions.

We will also leverage work being done in human presence detection to introduce a chip that can serve as the basis for an M55-based processing device that has advanced AI features. While we begin some critical future product advancements, we are winning at present in both our traditional operator base with multimedia products as well as in headset customers. Panasonic's recently announced True Wireless Earbuds feature 2 of our audio processing devices that offer our most advanced ANC and ENC algorithms.

Synaptics has an extensive technology portfolio that strategically positions the company in various high-growth markets. Chips are application-specific, rather than general-purpose, in order to optimize performance. Synaptics also leverages multimedia, voice, and audio technologies, focusing on enhancing human experience and communication products. Deep learning and neural networks have been adopted for data sense-making and interpretation. Mixed-signal integrated circuits allow digital and analog interfacing, crucial for products like touchscreens.

Wireless connectivity solutions are another strength, with a focus on Wi-Fi and Bluetooth standards like 802.11AX and Bluetooth 6.0 (these will be upgraded with an acquisition of intellectual property that I’ll discuss later). Video interface and compression technologies are designed for both consumer and commercial applications, while their imaging and modem technology find applications in printers, cameras, and fax machines. Capacitive technologies for fingerprint, position, and force sensing as well as multi-touch are significant for user-interface applications. Lastly, their display systems and circuit technology focus on optimizing display and touch functionality, extending to advanced automotive-grade solutions. Overall, Synaptics’ ability to integrate these technologies gives them a competitive edge.

Customers of Synaptics consists of large mobile and PC OEMs, IoT OEMs, auto manufacturers and consumer electronics companies. The latest 10-K filed in 2023 didn’t detail leading customers, unlike previous years where Synaptics would give a long list of top customers. The following nine companies were in the customer list from 2018 - 2022 (each of the five years): Dell, Google, Hewlett-Packard, Huawei, Lenovo, Oppo Mobile, Samsung, Sony and Vivo. I’ll note Ford and emerged in 2019 and was in it each year since as Synaptics leaned more into automotive.

The list of OEMs makes up the end customers of Synaptics, however, they are generally served through their contract manufacturers, supply chain partners and distributors. The 2020 10-K noted that sales to Fuhrmeister Electronics and Sharp Corp. accounted for 18% and 12 of Synaptics revenue, respectively. Only one direct customer (unnamed) made up 10% of sales in 2023. Relative to their history, customer concentration has gotten quite low if only one customer made up 10% of sales in 2023. In 2016 and 2017, three customers made up ~55% of net sales in each year. This is driven by the shift in product offerings from PC and mobile to IoT. CFO Dean Butler talked about the difference in customer concentration in IoT versus the legacy segments.

Really in the world, there's basically 3 PC OEMs that produce something like 97% of all the world's PCs comes from 3 OEMs, super concentrated, mobile phones, very similar. There's kind of about 6 names that produce almost all of the world's mobile phones. Now as you start going right on this chart, automotive is a great business. It's going from mechanical to digital. That's why a lot of semiconductor people like it. But there's really only sort of 20 to 30 automotive OEMs. It's a big market. They sell lots of cars, a lot of content, great expansion for semiconductors.

Then you go into enterprise…Now you're talking hundreds of customers. Finally, as you get broader and broader, what we think about in IoT is really core IoT, traditional IoT businesses. Now you're talking thousands, if not tens of thousands of customers. By the way, every logo on this chart is actually a Synaptics customer. So we've already been moving in this direction for quite some time.

The following chart shows revenue by geography. Because of the nature of selling to contract manufacturers, rather than OEMs, they generate most of their revenue abroad.

Synaptics employs a fabless manufacturing model, meaning they don't own or operate their own manufacturing, assembly, testing, or packaging facilities. Instead, they rely on third-party organizations, mainly based in Asia, to handle these aspects of production. The company focuses on their core competencies like R&D, technology advancements, and design engineering.

The wafers integrating Synaptics' designs are produced by third-party wafer manufacturers. These wafers are then sent to other third-party facilities for packaging and testing. The resulting products can be standalone Application-Specific Integrated Circuits (ASICs) or part of custom modules. These are either sent directly to customers or through various contract manufacturers, which could then assemble these into final products. This setup offers Synaptics scalability and reduced capital investment but also introduces supply chain vulnerabilities and dependence on a few key suppliers. They have attempted to mitigate these risks through long-term agreements and diversification of suppliers.

Synaptics introduced three risk factors in the 2023 10-K and one indicated challenges tied to this manufacturing model. Specifically, the company highlights that not owning their own manufacturing facilities means they can't reduce costs as rapidly as competitors who do. This makes them vulnerable to factors like inflation, tariffs, supply chain constraints, and increased component prices, which could all negatively impact their gross margins. Moreover, they must rely on forecasts to place orders with these third-party manufacturers, leading to the risk of excess or obsolete inventory if they overestimate demand, or lost revenue and market share if they underestimate it.

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Competition: In the IoT sector, Synaptics has a diverse range of SoC solutions targeting markets like home automation, STB/OTT platforms, and surveillance cameras. They're rubbing shoulders with heavyweights like Broadcom (AVGO), MediaTek, NXP Semiconductors (NXPI), and Ambarella (AMBA). They've also ventured into voice and next-gen audio applications, squaring off against companies like Cirrus Logic, BES Technic, Realtek, and Qualcomm (QCOM). For wireless IoT, they're in the ring with Infineon, Qualcomm, MediaTek, NXP Semiconductors, and Silicon Labs (SLAB).

On the automotive front, they provide touch and display solutions, competing against firms like Focaltech, Himax (HIMX), Novatek Microelectronics, and Microchip (MCHP). For PC and mobile applications, Synaptics' main competitors are Broadcom, Goodix, Focaltech, and STMicroelectronics (STM) in the touchscreen market, and companies like Novatek Microelectronics, Samsung LSI, LX Semicon, and Raydium in display drivers.

Now, how do they stack up against these competitors? In the IoT sector, companies like NXP and Broadcom are well-established, and Synaptics carved out some market share by leaning into niche offerings. The audio space is really crowded, and they have to face Qualcomm, a giant with deep pockets. That's no small task. The automotive sector is also competitive, but less crowded, giving them a good shot at establishing a strong position. In the PC and mobile sector, they face intense competition in a rapidly changing landscape, so agility and innovation will be key for Synaptics. Overall, they seem to be positioned well in multiple sectors but will need to bring their A-game to outmaneuver these strong competitors.

Shifting to Synaptics’ financial performance, which has varied greatly in its long history. Synaptics has ridden technology waves that have driven strong growth at times and significant decelerations. I extracted segment revenue over the since 2013 to show have sales have evolved. Recall the segments are mobile, PC and IoT products. Mobile made up the majority of sales for Synaptics in the mid 2010s.

Synaptics built out mobile products through two notable mergers. The first was for Validity Sensors for $128M in 2013, a maker of biometric sensors (fingerprint authentication), causing a jump in sales in 2014. The next was for Renesas SP Drivers (“RSP”), which specialized in chips that controlled LCD screens. Synaptics bought RSP for $463M in June 2014 and it contributed $715M to sales in 2015. Revenue that year was $1.4B, up 109% from 2014, though only up 5.3% if you strip out the contribution from RSP (organic increase).

Revenue for Synaptics hit a peak in 2017 and it began to steadily drop, largely because of Synaptics mobile products business. Synaptics ended up divesting a major product line within mobile in 2021 and now the mobile products business makes up a fraction of Synaptics revenue. Instead, Synaptics has grown via its IoT products business in recent years.

When I read about Synaptics’ product history it made me think of technology companies that have risen and fallen by riding waves they can fit within. Think about well-known stories like Blackberry or Nokia. There’s multiple products that came and went for Synaptics, such as the iPod scroll wheel, and a more recent example being mobile fingerprint sensors.

Fingerprint sensors first emerged in 2007/2008 and Synaptics jumped into the market in 2013 through their noted acquisition of Validity Sensors. Fingerprint sensors gained widespread adoption around 2014 when Apple launched touch ID on the iPhone 5s (seems like so long ago). Synaptics became a major supplier of sensors to the Android market during 2014 - 2016, helping drive sales higher. However, fingerprint sensors fell out of favor while facial recognition gained traction in 2017 and mobile product sales lagged. I bring this up because it’s an example of Synaptics riding a wave of technology.

The amazing aspect of their transition away from mobile is that it’s not the first time the company made a major pivot. Synaptics’ business was dominated by PC revenue from inception into the 2000s and they made a similar transition to mobile as the company more recently made toward IoT products.

The company has more recently ridden a wave of providing chips within the likes of smart speakers and other popular consumer electronic components. However, the market turned on Synaptics in 2023 with revenue down -22%. You can see from the chart displaying revenue by segment that sales for each segment decreased in 2023. The drop was due to excess inventory build up which can be attributed to demand softness and macroeconomic uncertainty. All segments were down in 2023 as customers preferred to deplete existing inventories and slow purchases from Synaptics. Revenue was down -16% YoY in Q2’23 (ended December 31) and each quarter since growth declined further with Q4’23 revenue down -52% compared to the prior year. Note that Synaptics’ fiscal year ends in late June and they filed their latest 10-K on August 18.

The inventory challenge experienced in 2023 was within direct customers. In addition, their own inventory levels have been bloated. The days of inventory outstanding (amount of days it takes to sell the inventory amount) was at its highest level ever at the end of Q4’23, according to data from Koyfin. This is a notable attribute given one of the risk factors added called out potential obsolete inventory. Technology moves fast so you don’t want to be a company with inventory that quickly becomes worthless.

Capital Allocation: In order to analyze capital allocation, I’m going to compare Synaptics against Broadcom (AVGO). When it comes to product overlap, Broadcom is the closest to Synaptics. Broadcom is also much larger and more diverse in covering similar products to Synaptics and more. Synaptics generated $2.4B in cash from operations in the last 10 years (fiscal 2014 - 2023). $311M (13.1% of cash of operations) was spent on capital expenditures, $1.16B (48.7% of cash of operations) was spent on stock buybacks and $1.85B (77.9%) was spent on acquisitions. Synaptics hasn’t ever paid a dividend. Note these percentages don’t sum to 100%. A company can spend more or less than it’s cash flow for the year that tapping into its cash and/or debt or spending less than its cash flow and adding to its cash reserves.

Synaptics has employed an opportunistic approach to buybacks, which have been relatively aggressive this year. The opportunistic approach is a reason I was drawn to Synaptics (and almost all of the stocks I cover in this newsletter). I was recently on Verity’s podcast Differentiated that was published on September 24, 2023. In it, I chatted about Synaptics’ efficient buyback execution this year. Specifically, I pointed out that since the CEO and CFO were brought on in 2019, they were timely by buying back shares in calendar quarter Q1’20 during the COVID-induced pullback then refrained from buying back shares for the next 2.5 years. Synaptics returned to the market for its shares in calendar Q3’22 after the stock was in the midst of a multi-quarter drawdown and fluctuated the pace in response to volatility in 2023. Since calendar Q3’22, they bought back at an average of ~$92 and during that period the stock closed at ~$106 on average. You can check out the full conversion here (episode seven). I talk about Synaptics 18 minutes into the podcast.

The biggest year for acquisitions on a dollar basis was in 2020 when Synaptics bought DisplayLink for $444M and wireless connectivity assets from Broadcom for $250M. DisplayLink brought on video compression semiconductor-based solutions used in docking stations and other applications. Management discussed the Broadcom assets acquired in 2020 in the investor day conference and pointed out that it was a $65M business in terms of revenue when acquired and has grown to $225M in 2023. Synaptics more recently added an intellectual property deal with Broadcom on July 31, 2023 for $130M that brings on WiFi 7 technology, among other IP. That will bolster Synaptics product offerings and lift average selling prices for some wireless products by 30%, according to Synaptics management. Sales via that deal should begin to materialize near the end of fiscal 2024.

The four buckets of capital allocation from the cash flow statement (CapEx, buybacks, M&A and dividends) capture most investment activity for companies where manufacturing is material. For technology companies, however, the investment in internal growth is largely in the form of R&D. The accounting difference is R&D costs are expensed and shown on the income statement whereas CapEx is capitalized and thus shows up on the cash flow statement. CapEx is tangible and easily measurable. R&D is instead spending on less tangible assets, such as investment in emerging technologies, which often involves costs like engineer salaries. At Synaptics, cumulative R&D costs since 2014 total $3.1B which is slightly more than the amount spent on buybacks and M&A combined.

By comparison, Broadcom has a more balanced capital allocation profile. Broadcom generated $75.3B in cumulative cash flow from operations in the past 10 fiscal years (2013 - 2022). Just $5.4B (7.2% of cash of operations) was spent on CapEx, while $44.8B (59.5%) was used for acquisitions (net of divestitures), and $24.3B (32.3%) was spent on buybacks. Where Broadcom differs notably is that they spent $29.3B on dividends (38.9%). Similar to Synaptics, CapEx isn’t the only figure that covers internal growth. Broadcom spent $31.3B on R&D, which is equal to 18.2% of cumulative revenue over the past 10-years. Synaptics’ R&D spend over the last 10-years equals 21.0% of its revenue. Another way to normalize for company size would be to add R&D and CapEx together the divide by cash flow operations, before R&D, as the denominator. This approach is an unconventional way to add R&D and CapEx to understand total reinvestment into the business absent tax impacts. Regardless, with this methodology, the reinvestment amount for Synaptics would be 62% and 34.5% for Broadcom. So no matter how you cut it, Synaptics has reinvested more heavily than Broadcom.

It’s not paid off, however, given Broadcom has grown its FCF per share at a compounded annual rate of 39.9%, beating out Synaptics’ FCF per share CAGR rate of 12% in the last 10-years. This indicates Broadcom is more efficient via reinvestment into the business and/or its been more efficient through inorganic growth via M&A. Broadcom has been known for its savvy history of acquisitions.

Management and Incentives: Michael Hurlston joined Synaptics as CEO in August 2019. He was CEO of Finisar (former FNSR) from January 2018 until August 2019 when the communications components company was acquired for $3.2B. Hurlston joined Broadcom in 2001 and worked in increasing roles through 2017 where he was most recently SVP and GM of Mobile Connectivity Products/Wireless and Connectivity Division, giving him good familiarity with the acquired assets in 2020.

CFO Dean Butler also joined Synaptics from outside by taking on his chief finance duties in October 2021. Before that he was VP of Finance at Marvell Technology (MRVL) for three years where he led strategic initiatives, including M&A. Butler was at Broadcom prior to Marvell and also spent team at Maxim Integrated (former MXIM), so he’s made the rounds on finance teams at semiconductor companies.

The third highest ranking executive, according to compensation, is SVP & GM of Enterprise and Mobile Saleel Awsare. He oversees leading products such as the TouchPad, fingerprint, and video interface business products through DisplayLink (docking stations, video adapters and USB monitors). Awsare joined Synaptics in July 2017 when it acquired Conexant where he similarly oversaw audio and imaging products.

Hurlston, Butler and Awsare each participated in the September 7 investor day conference. As did SVP & GM of Wireless Products Venkat Kodavati and SVP and GM of IoT Processor Vikram Gupta. Gupta is new to Synaptics having joined in January 2023 and previously held a similar title/role with Infineon Technologies (INFN). Kodavati also has an interesting background having joined Synaptics in 2020 when it acquired the wireless assets from Broadcom. Kodavati was a senior director at Broadcom in wireless connectivity and has spent most of his career in the space. He even co-founded and sold a start-up producing wireless IP. Much of the potential growth at Synaptics will come from wireless IoT products and Kodavati will be orchestrating that.

The compensation program for executives of Synaptics is made up of salary, modest annual cash bonuses and the bulk of compensation is in the long-term incentive. For CEO Hurlston, his total compensation over the past four years has averaged 4.3% from salary, 6.8% from the annual cash bonus and 88.8% in stock-based compensation (“SBC”). Those figures are similar to the target amounts for 2023. Other executives had 9.7% of their total compensation paid in the form of salary, 8.5% in annual cash bonus and 78.9% in the form of SBC. The SBC component can be further broken out with ~24% paid in the form of RSUs (stock that vests over time), ~24% in the form of performance-stock awards (“PSUs”) that vests according to EPS targets and ~53% in market stock units (“MSUs”) that vests according to relative total shareholder return (“rTSR”).

The percentages stand out compared to peers because they lean so heavily on stock-based compensation. I looked at a few other mutual peers (each company has each other listed as a peer) of similar size such as Lumentum (LITE), Diodes (DIOD) and Cirrus Logic (CRUS). Those companies have higher percentages paid in the form of salary and annual target bonus with smaller percentages in SBC. This is a combination of Synaptics paying a modest salary and bonus, and high SBC.

I’ll dive into the key incentives of management starting with the annual performance bonus. The target amount is 130% of the salary for Hurlston and 75% for other executives. The payout is based on equally weighting a revenue target, non-GAAP gross margin and non-GAAP operating profit. The non-GAAP versions of those strip out M&A-related cost and stock-based compensation. In each case there’s a minimum performance level in order to get any payout and a maximum payout of 200%. The compensation committee sets the targets in the beginning of the near, however, Synaptics doesn’t provide full-year outlook, only quarterly. Synaptics’ 2022 revenue was $1.74B and they set the target goal for 2023 at $1.84B indicating they were surprised by the decrease in revenue.

The PSU awards at Syanptics are earned based on a one-year performance period of non-GAAP EPS. It’s unusual to have such a short-term performance period for PSUs; one year performance-periods are generally used for cash bonuses. Similar to the cash bonus, there’s a minimum and maximum performance payout (0% and 200%). For 2023, the compensation committee set a non-GAAP EPS target of $12.47 but the actual result of $8.12 meant that executives received a payout of just 0.458%.

The last and most import performance incentive of management is via the MSU awards. They are dependent on how Synaptics' relative Total Shareholder Return (“rTSR”) compares with other indexes over a one, two and three-year performance period. For awards after 2021, the benchmark is the Russell 2000 Index. Before that, it was the S&P Semiconductors Select Industry Index. Depending on their rTSR achievements, the payout can range from 0% to 300% of target shares (up from a max of 200% in prior years). Notably, if Synaptics' TSR is below the 25th percentile, there's no payout, but hitting or surpassing the 80th percentile can lead to a payout of 300% of the target. Furthermore, the rewards are structured to be released gradually over three years with one-third eligible for release each year and a true up based on final achievement.

The value of stock-based compensation at Synaptics seems excessive for a $3.2B company. Though I do like the incentives by focusing on rTSR with nearly half the total compensation based Synaptics beating other small-caps. The one critique I have is using the broad index of the Russell 2000 rather than an industry-specific index.

Outlook: In order to understand the outlook I’ll reiterate that Synaptics currently has a niche product offering and aims to serve a broader market. This quote by CEO Hurlston speaks to that well:

Our product line is very much targeted to high performance. I think we've discussed it on in previous calls where, for the most part, we're moving video from one device to another. And that requires very high bandwidth. It requires quite high performance.

Where we're aiming our roadmap over the next couple of years is a more basic connectivity, simple point-to-point connections, whether that be over Bluetooth, whether that be over the ZigBee technology, whether that be over Wi-Fi. There is kind of a margin-rich and high TAM area there that we have totally not tackled. So our engineering investment right now is very much geared toward retuning our roadmap to go after that broad market. Eventually, we think that there's going to be opportunities for us to bring in our SoCs, our processors and either through integration or through a bundling type of scenario where you can pull through a lot more content in that broad market area.

To get a better idea of the difference, imagine Synaptics makes a custom semiconductor chip for a modern security camera that’s operating 24/7 or even a smart speaker that plays music but is also always alert for questions and instructions. These are high performance chips with high bandwidth. Conversely, low bandwidth chips could be in products such as smart light bulbs and door locks, industrial sensors for temperature and humidity or healthcare diagnostics products. In these cases, chips could be repurposed. By going broad, Synaptics’ serviceable addressable market (“SAM”) will greatly expand. Synaptics provided some updated SAM estimates in their September investor day meeting. On the left side is an estimate of the growth in the IoT semiconductor market that’s expected at a CAGR of 12%, which is the fastest subsegment of semiconductor markets. On the right side is the expanded SAM.

The goal of serving a broader market is enough of a shift for Synaptics that they will be changing their reporting segments to core IoT, enterprise + automotive (which will include the current PC products) and mobile. Core IoT, which will feature wireless connectivity products and edge processing, is expected to be the fastest-growing of the segments.

Despite the strong expectations for core IoT of 25-30% annual growth, the inventory channel is still working its way to normalization which should take another two quarters, or three, covering most of fiscal 2024. Thus, Synaptics isn’t expected to grow this year. In addition, the new potential product offerings via the latest IP asset acquisition from Broadcom won’t come into play until late in 2024, which will then allow Synaptics greater offerings thereafter.

Management’s revenue expectation for the next five years is quite ambitious. I expect there’s going to be greater competitive pressures as they shift to broad-end markets. For their benefit, Synaptics has good relationships with a lot of major technology companies which should help build trust in getting their chips into more products.

To understand if their 12% revenue CAGR projection is realistic, let’s compare their history. Revenue has grown at a CAGR of 4.1% over the last 10 years through fiscal 2023 and the growth rate is at -2.1% since 2019 when current top management joined Synaptics. Those figures don’t give me much confidence in the high goal management recently provided.

Synaptics also provided a long-term non-GAAP gross margin target of 57%, which compares to ~60% in the prior two years but an average of 48.8% in the prior six years which is also close to the 20-year average. It shows they’re expecting some margin abatement after experiencing strong margins in the last three years. To their credit, Synaptics did hold onto its elevated profit margin in fiscal 2023 despite pricing pressure amid the glut in inventories in 2023 so perhaps margins can continue to be higher than the historical norm. Separately, I should note that Synaptics has emphasized recently that margins are correlated to the product mix, specifically the weighting of IoT, which is a higher margin than PC and mobile. More IoT means higher margins so future years should pull margins higher again.

Guidance for fiscal Q1’24 included a GAAP gross profit margin of 45.5% and non-GAAP gross profit margin of 53.5% suggesting further margin compression to start the year. Note that non-GAAP gross profit margin is about 600 basis points higher than GAAP gross profit margin because Synaptics takes out acquisition-related costs and a little SBC.

The upcoming transition in product offerings has been labeled as “margin-rich” by management. Synaptics would then compete more closely with companies such as Silicon Laboratories (SLAB) which have even better margins. The following scatterplot looks at gross profit margins and revenue growth by those in the SPDR Semiconductor ETF. Synaptics is currently in the middle of the margin territory.

Valuation: I built a financial model forecasting financial performance over the next five years to produce a DCF valuation. Management gave revenue guidance of $230M for Q1’24, which would be -48% below Q1’23. It will also reverse the QoQ decline in sales after posting revenue of $227M in Q4’23. Taken together, revenue growth will still likely be negative in fiscal 2024 and should reverse on an annual basis in 2025. What gives me confidence in the turnaround is that Synaptics has been undershipping by about $100M a quarter. That means end-customer demand is still strong. So if the inventory channel of their direct customers were normal sales would be ~$330M in Q1’24.

Moving onto annual sales figures, I expect Enterprise & Automotive and Mobile segments to grow at a steady state over the duration of the DCF. Auto is relatively small for Synaptics but could be strong this year. Core IoT is the driver of growth for Synaptics. The wireless connectivity portion of the business had rapid growth already and that can carry Core IoT over the next five years. In addition, new product offerings could boost sales further beginning in 2025. Overall my revenue estimates are below the consensus analyst estimate for both 2024 and 2025, and the overall trajectory is lower than Synaptics’ management expectation of 12% CAGR.

The EBITDA margin should dip in 2024 before picking up in 2025 and remain steady. There’s a few gives and takes here. Margin benefits for new product offerings can pull margins higher, offset by the gravity of settling back near the historical EBITDA margin. The average EBITDA margin for Synaptics over the last 20 years is 15.4% when there was a higher weighting of lower margin mobile and PC products.

CapEx and depreciation and amortization are expected to be near the five-year average, as a percent of sales. Though you could argue Synaptics needs to invest even more heavily than they have been. Cash flow projections are as follows.

The other critical inputs of the DCF model are the discount rate which is 10.75% based on a beta of 1.8 and the current 5-year risk-free rate of 4.6%. Synaptics’ average trailing EV/EBITDA multiple in the last 10 years is 13.9 and the median is 12.0. This DCF will exit at 13X. The summary is as follows, which calculates a fair value of ~$100, roughly 20% higher than the current price.

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Conclusion: Synaptics next frontier of semiconductor growth could be quite fruitful though I have my reservations the company can grow at a CAGR of 12% in the next five years. There’s going to be a new business cycle for Synaptics (they experience them frequently) and higher stock prices with that, at some point. The bear case is that Synaptics grows at a CAGR of 5% or less and EBITDA margins fall back to the historical norm near 15%. The bull case scenario would be that Synaptics realizes higher growth from its IoT portfolio and higher EBITDA margins than 20%. The 20% implied upside in the stock, according to my model, isn’t enough to entice me to stamp this with a buy right now. I’d rather wait to see some growth materialize or wait for a cheaper stock prices.

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Disclaimer: This is not advice to buy, sell or hold any stock referenced. Do your own due diligence. I have no position in any stock mentioned in this report. Like any financial analyst, doesn’t mean I’m not biased.

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AZEK’s is known for its decking line called TimberTech which is second in market share behind the more well-known Trex decking product. Trex is synonymous with engineered decking. When you see composite decking you think of Trex. While there’s significant overlap in the products for AZEK and Trex, AZEK has diversified its revenue through different product types compared to Trex, a subject I’ll dive into more in the competition analysis section.

AZEK has been a market innovator for over three decades, driving growth by leveraging its distinctive manufacturing capabilities, advanced material science, and R&D expertise. They have excelled in creating new, top-quality products, and their consistent investments in sales, marketing, R&D, and manufacturing solidify their standing as a market leader. AZEK has an impressive track record of introducing disruptive products and effectively expanding its portfolio, meeting consumer needs across a wide range of price segments. They have earned a reputation as a premium brand through their commitment to customers and developing innovative products that blend the latest style and design trends with their unique material science expertise and proprietary production technologies.

Sustainability is a cornerstone of AZEK's operating platform. From product design to raw material sourcing and manufacturing, they prioritize the use of recycled materials like plastic waste, recycled wood, and scrap in their products. AZEK's investments in recycling capabilities have not only heightened the sustainability of their operations but also reduced their costs. Their TimberTech PRO and EDGE decking lines are primarily composed of recycled materials. AZEK's recycling programs diverted around 500 million pounds of waste and scrap from landfills in fiscal year 2022. Most of their TimberTech, AZEK Exteriors, and Versatex products are recyclable at the end of their useful lives.

AZEK's growth strategy is multi-dimensional, focusing on conversion of wood products to AZEK’s engineered materials, brand building, product innovation, multi-channel expansion, margin expansion through enhanced recycling and productivity, and strategic acquisitions to expand their addressable market. The intent is to drive profitable growth exceeding market rates in their serviced markets.

There’s two reportable segments: 1) residential segment that makes up 86% of total sales; 2) commercial segment that makes up the remaining 14%.

The residential segment is made up of engineered outdoor living products made up of decking, railing, trim and moulding, siding and cladding, pergolas and cabanas that are intended to drive consumers away from wood. AZEK says of its engineered products:

These products are primarily manufactured using capped wood composites and PVC technology that are aesthetically similar, yet functionally superior, to finished wood, as they require less maintenance, do not rot or warp, are resistant to water, insects, stains, moisture, mold, mildew, scuffs and scratching, and do not require painting or staining for protection.

I didn’t realize how much engineered decking boards have evolved over the past 30 years, but there’s been some good strides to make a quality product that doesn’t warp, scratch and crack as easily. Part of that is through ‘capping’ which is surrounding the board with a protective polymer layer. This is a link to AZEK’s webpage for PVC vs. Composite decking. Here’s another link showing how increasing the capping helps extend the life of the boards.

My quick summary of some history to engineered decking materials. The first generation of composite decking emerged in the late 1980s when the scarcity of trees became more apparent. The initial version was a combination of wood fibers and recycled plastic, often polyethylene. It aimed to provide the appearance of wood with increased durability and less maintenance. However, the first generation was susceptible to color fading, warping and mold. In response, manufacturers introduced second generation known as capped composite decking around the early 2000s. These products have a core made of wood and plastic, but they're coated with a protective polymer shell or cap. The third and more recent generation improved performance further by offering fully capped designs and utilizing advanced materials.

Decking and railing: AZEK is one of the only decking manufacturers to offer both capped composite and PVC decking products. Emulating natural wood, AZEK's products resist fading, cracking, and rotting, coming across as a more cost-effective solution in the long run. The wood used in the core is 100% recycled and the decking material overall is made up of 85% recycled material, which increased in the past year. The decking offerings—TimberTech AZEK, TimberTech PRO, and TimberTech EDGE—provide a variety of colors, textures, and styles, ranging from entry-level to premium options with industry-leading warranties. Features such as slip resistance, heat dissipation, fire resistance, and mold protection set AZEK's products apart. Alongside decking, AZEK provides attractive, high-quality, low-maintenance railing solutions through its TimberTech, ULTRALOX, and INTEX brands, effectively challenging traditional materials by averting problems like warping and rust. The aluminum railing products afford unobstructed views, and AZEK's proprietary technology facilitates quick on-site customization. These products are versatile, complementing the company's decking lines or serving the broader, stand-alone market. AZEK also offers functional and decorative accessories such as drink rails, lighting packages, and gate kits.

Trim and Moulding: AZEK leads in designing and manufacturing PVC trim and moulding products through the AZEK Exteriors and VERSATEX brands. Similar to other product lines, AZEK’s trim and moulding products emulate the aesthetics of wood but are more durable and require less maintenance. With features like moisture and insect resistance, they are increasingly used for both exterior and interior applications, including home accents like pergolas, arbors, and unique interior spaces. The full line includes trim boards, sheets, skirt boards, moulding, specialty siding, and various innovative solutions like PaintPro trim and TimberTech AZEK Cladding. Additionally, AZEK offers custom milled solutions and accessories such as adhesives and bonding solutions. The benefits are highlighted with these photos from the investor deck that show the durability and ease of maintenance when using engineered materials.

This product line piqued my interest because just last week some wasps squeezed through where my siding and window trim was supposed to be touching and made a hive. Perhaps if I had more durable composite trim and siding that wouldn’t have been an issue. Back to AZEK.

Pergolas and Cabanas: AZEK is new to the pergola market through its acquisition of StruXure in December 2021. The pergola (and railing) offering was built out further through the acquisition of INTEX in August 2022. The acquisitions of StruXure is a natural fit for the TimberTech portfolio as StruXure is also focused on recycled, engineered materials that will help drive wood conversion. Pergolas and cabanas, which provide shade and rain protection, are a fast-growing niche that represents a $1.0B market opportunity. The announcement of the acquisition of StruXure said “StruXure delivered net sales of approximately $50 million and mid-teens Adjusted EBITDA margins in calendar year 2021, and was named to the Inc. 5000 Fastest-Growing Private Companies list for the seventh consecutive year.”

Roughly 80% of fiscal 2022 sales of the residential segment came from residential repair and remodel while the remaining 20% went to residential new construction. The illustrations below are for fiscal 2021.

AZEK leverages its manufacturing platform and material technology from the Residential segment to its other segment, Commercial. The Commercial segment is made up of two product lines - Vycom and Scranton Products. Commercial generated revenue of $187M in fiscal 2022 (14% of total sales), which was up 38.7% from the prior year. Similar to the Residential products, Vycom and Scranton Products produce sustainable, low-maintenance materials that are intended to replace traditional materials such as wood and metal. Vycom’s end markets are outdoor living, graphic displays, recreation and playground equipment, marine and other various applications. Scranton Products makes storage solutions mostly for schools, stadiums, recreational and commercial facilities. Demand for Commercial segment products is driven commercial construction activity, material conversion and a secular trend of increased privacy.

Distribution and Sales: AZEK's distribution strategy involves a comprehensive network that caters to both the Residential and Commercial segments. In the Residential segment, the company sells products through over 5,000 professional dealers and various home improvement retail outlets, served by around 40 distributors with over 150 branch locations across the United States and Canada. Exclusive relationships, digital tools, and marketing initiatives help drive sales and brand loyalty. The Commercial segment's distribution involves around 125 engineered product distributors for Vycom products, primarily selling to OEMs, and approximately 850 dealers for Scranton Products that cater to industrial and commercial customers. Throughout fiscal year 2022, roughly 99% of gross sales came from the U.S. and Canada, but the company also maintains distributors outside these regions as well.

AZEK's Residential segment leverages geographically based sales teams to target contractors, architects, and builders, supported by comprehensive marketing campaigns and digital tools. Education initiatives such as AZEK University and the AZEK Pro Rewards program drive brand preference and loyalty. Attracting more contractors and architects is important to AZEK as the brand leans toward the pro channel rather than retail DIYers.

Only one distributor accounted for more than 10% of company-wide sales, Parksite, a prominent distributor of building products that typically serves lumber yards and other building product dealers. Parksite accounted for 20.3%, 23.3% and 19.3% of revenue in 2020, 2021 and 2022, respectively. As a comparison, Trex relies more heavily on Home Depot and Lowe’s which is discussed prominently in their 10-K. Three customers combined to account for 56%, 61% and 64% of company-wide sales for Trex in 2020, 2021 and 2022. It’s nice to see AZEK is much more diversified on the distributor front than Trex.

In the Commercial segment, Vycom focuses on engineered polymer solutions for various industries, using direct territory managers and manufacturing representatives to increase market penetration. Scranton Products employs a direct sales approach, targeting architects and facility managers to create demand across institutional and commercial markets. Overall, the strategy emphasizes customer engagement, education, and market-specific targeting to foster growth.

Operations: AZEK operates as a vertically-integrated U.S.-based manufacturer, with a focus on quality products at competitive costs, largely facilitated by domestic production. The company's manufacturing operations, spread across 14 facilities in 13 locations, utilize a blend of virgin polymers and recycled materials in 85% of gross sales. Recent expansions include manufacturing facilities in Boise, Idaho, and acquisitions like PVC recycling Return Polymers.

Raw materials used by AZEK include petrochemical resins, reclaimed polyethylene, PVC material, waste wood fiber, and aluminum. Supply contracts are generally short-term, with fluctuating prices influenced by market conditions and crude oil prices. AZEK actively manages the effects of these fluctuations by diversifying its supplier base, increasing recycling use, and investing over $75 million to enhance recycling capabilities from 2017 to 2022. Dependence on single suppliers for specific raw materials creates potential risks, but the company’s strategies aim to mitigate interruptions and maintain quality.

Competition: The Residential segment competes against Trex (TREX), Fiberon, which is owned by Fortune Brands , Deckorators of UFP Industries , Oldcastle APG, Westlake , Kleer Lumber and CertainTeed. The Commercial segment competes against a relatively fragmented market. The named competitors of Vycom are Mitsubishi Chemical Advanced Materials, Rochling Plastics, 3A Composites USA, Simona AG and Kommerling Plastics. Scranton Products’ named competitors are Global Partitions Corp., Hadrian Manufacturing and Bradley Corp.

I searched online for top rankings of composite decking to get an idea of where AZEK stacks up against the competition. The first Google hit is House Beautiful which ranks TimberTech number one due to its aesthetics. The second Google hit is Consumer Reports (paywall). Consumer Reports tested all of AZEK’s named competitors and more to produce a top four for 2023. Envision EverGrain was number one with TimberTech’s Harvest Collection at number two, Fiberon Horizon at three and TimberTech’s PRO Legacy collection at four. The next Google hit that provided rankings was Deck Bros who also had TimberTech at number one due to wood-replication, shipping and superior capping method.

Historical Financials: AZEK debuted in a June 2020 IPO and provided segment financial data back to 2018. For the following analysis, I took segment results and backed into rough figures (for instance product results aren’t detailed in financial statement but AZEK lists the percentages of sales generated by product type). I was also able to get 2016 and 2017 financials by backing into them based on the growth figures AZEK gave in the IPO prospectus, therefore, deconsolidated numbers may not perfectly sum to company-wide net sales. Note that AZEK’s fiscal year ends on September 30.

I also want to bring up a little more history on AZEK. PE firms Whitney & Co. and Clearview Capital sold Compression Polymers Holdings, AZEK’s predecessor company, to private equity firm AEA Investors in 2005 and through a merger turned into CPG International. CPG was reporting financial results through 10-Qs and 10-Ks from 2006 through 2010. AEA had filed IPO documents to float the company in 2011 but changed their mind and ended up selling to Ares Management and Ontario Teachers Pension Plan (“OTPP”) in 2013 for around $1.5B, according to a Reuters article. Naturally, management would turnover and CPG re-branded as AZEK in 2018. When AZEK ended up hitting the public markets in 2020, Ares and OTPP each held 48% pre-IPO stakes that were diluted to 37% through the IPO. The rest of the shares were held by management/employees. I bring all this all to point out that there is some old data on AZEK’s predecessor entity, though the following financial analysis will focus on AZEK’s current operating company.

The first segment is Residential which made up 86.2% of company-wide sales in fiscal 2022. Residential has grown at a compound annual growth rate (“CAGR” from here on) of 16.5% during the seven-year period from 2016 - 2022 and 12.0% during the 15-year dating back to 2007 (using CPG financials). AZEK has historically split the residential segment further into decking and railing sales and exterior product sales, then more recently broke out pergolas sales. Decking and railing made up 65% of segment sales in 2022, and as the largest base of business, has driven growth in recent years. Decking and railing sales did regress toward the end of 2022 and overall the year was flat. However, sales of exterior product continued to be strong and was up 20% YoY in 2022.

As far as margins go, AZEK only provides adjusted EBITDA on a segment basis.

We define Segment Adjusted EBITDA as a segment's net income (loss) before income tax (benefit) expense and by adding to or subtracting therefrom interest expense, net, depreciation and amortization, stock-based compensation costs, asset impairment and inventory revaluation costs, business transformation costs, capital structure transaction costs, acquisition costs, initial public offering costs and certain other costs.

I try not to use adjusted EBITDA when analyzing companies and I never think stock-based compensation should be removed to adjust EBITDA. But sometimes you’ve got to work with what you’ve got, and adjusted EBITDA is the only margin provided on a segment basis. As the table shows, adjusted EBITDA margins have held pretty steady since 2018 at around 30%, dipping to the lowest level in 2022. There’s been more asset efficiency with sales increasing as a percent of assets for the segment.

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The next segment is commercial which made up the remaining 13.8% of company-wide sales in 2022 (much lower than what it was before 2011). Commercial had a strong 2022 with growth of 39%, significantly better than any other year. Both brands — Vycom and Scranton Products — experienced growth and it was “exceptional” for Vycom helped by the end markets of outdoor living, marine, semiconductor and industrial. Moreover, margins for commercial greatly improved in 2022 driven by operational optimization and cost savings initiatives. Management had also called commercial margins depressed in 2020 so there was a lot of effort to improve that business in the last two years.

Performance of the commercial segment has regressed significantly so far in fiscal 2023, a topic I’ll cover more in the outlook section. For now I’ll note that revenue for commercial was down nearly -21% in the first nine months of fiscal 2023. Maybe this shouldn’t be a surprise as AZEK had an interesting change in the latest 10-K which deleted the following sentence from the prior year. “We expect to continue experiencing significant growth in Scranton Products' sales in the commercial markets, which we believe is driven primarily by an increased focus on bathroom privacy considerations, design and aesthetics.” Deleting a sentence that says we expect to continue to experience significant growth is foreshadowing that growth will moderate or even turn negative.

The next illustration stacks sales by product category to show the change over time. The performance of the Exterior residential products has been impressive and therefore has more recently made up a larger piece of the pie in terms of sales.

When it comes to publicly traded companies, there’s not a closer peer than Trex. Unfortunately, Trex hasn’t been granular with segment analysis by only reporting residential and commercial results. And for Trex, commercial only represented slightly less than 5% of sales in 2022 and 2021 and was therefore an immaterial part of the business. In fact, commercial had negative EBITDA margins and Trex sold the business in December 2022 for a paltry $7.3M.

The following chart plots out AZEK’s revenue for just the residential segment against Trex’s company-wide sales. It’s nice to look at the quarterly data, rather than annual fiscal data, because Trex’s fiscal year ends on December 31, unlike AZEK’s September 30 fiscal year-end. Trex sports a market-cap of ~$8B and AZEK has a market-cap of about $5B, which is quite the difference considering AZEK has done more sales in just its residential segment. However, Trex does have solidly better margins. AZEK’s (unadjusted) EBITDA has averaged 17% since 2017 and Trex’s EBITDA margin has been 28% over that period. AZEK’s margins are dragged lower by the commercial segment while the residential segment has had similar EBITDA margins to Trex.

According to investor presentations and commentary on earnings call, Trex and AZEK combined for about 70% of the composite decking market. AZEK doesn’t break out decking and railing revenue on a quarterly basis so it’s hard to compare apples-to-apples performance. The above chart, instead, shows AZEK’s residential revenue which includes exterior products. Trex’s exterior products are immaterial as exterior product revenue is generated through licensing agreements. When you combine the annual product revenue mix AZEK reports (65% of residential came from decking and railing in 2022) to the quarterly data it appears AZEK and Trex have trended on similar paths and neither is making headway in capturing market share from each. Management teams of both companies have been vocal about goals of taking market share from wood, rather than other composite decking manufacturers.

Capital Allocation: To analyze AZEK’s capital allocation history, I’m going go to compare Trex. I generally look back 10-years to understand capital allocation and for AZEK there’s six years available.

Since 2007, AZEK has generated $631M in cash flow from operations. 90.3% of that amount went back into the business through capital expenditure to grow or maintain the existing business. AZEK was also aggressive in M&A by spending the equivalent of 67% of its cash from operations on acquisitions. The largest was in 2018 by acquiring Versatex Building Products for $271.2M in total consideration which contributed significantly to AZEK’s exterior portfolio. That year AZEK also bought Ultralox for $23.4M to bolster the decking railing products. The other significant acquisition to make a dent on the use of cash flow was StruXure in 2022 to bring on pergolas for total consideration of $82.7M.

AZEK has never issued a dividend, but the company has returned capital via buybacks and was active in 2022 at what now looks like depressed prices. In aggregate, 15% of cash from operations since 2017 went toward buybacks. Opposite of the buybacks, AZEK garnered $817M in proceeds from the 2020 IPO. The money was used to pay down debt and in the table below it shows net debt dropping from roughly $1.0B in 2019 before the IPO to $250M by the end of fiscal 2020. Private equity investors like to operate companies with high leverage so it was an appropriate move to dilute via an IPO and rebalance the capital ratio by paying down debt.

As a comparison, Trex has produced $1.3B in cash from operations since 2013, and 53% of that went back into the business via capital expenditures, which is more modest than AZEK. Trex has also differed on M&A with just 5.5% of cash from operations going toward acquisitions (compared to AZEK 67%). Instead, Trex was much more active in buybacks by spending 61% of its cumulative cash flow from operations to buyback stock. Both AZEK and Trex have opportunistic histories of buybacks and I suspect the ratio of cash going towards buybacks over the last 10-years for AZEK would’ve been higher had they not been privately held. The last bucket of capital allocation to note is dividends and similar to AZEK, Trex hasn’t returned capital via dividends.

As noted, Trex’s M&A spend has been limited, and since 2013, it’s only included one acquisition which was for Stadium Concepts for total consideration of $71.8M. Stadium Concepts made up Trex’s commercial segment, which was later written down via an impairment charge and sold for $7.3M last year. That means their one-off try at M&A was a failure (point AZEK).

Management: AZEK has been led by Jesse Singh since June 2016, when he joined the company in his current role as CEO. Before that Singh, 57, was with 3M (MMM) where he held titles such as chief commercial officer, president of 3M’s health information systems business and VP of stationery and office supplies business that featured Post-it and Scotch tape brands. Those subsidiaries have different dynamics than building products but he’s nonetheless executed well in his role as CEO at AZEK.

CFO Peter Clifford similarly joined AZEK from outside and has been with the company since August 2021. He also similarly comes without direct building products experience, in fact Clifford was most recently COO and president of healthcare company Cantel Medical (former CMD). Clifford was also CFO of CMD, and before that, unit CFO for reporting segments of IDEX Corp. (IEX). Before Clifford was CFO of AZEK, Ralph Nicoletti held the position for just two years. He retired in his mid-60s and appeared to serve as a stop-gap CFO while the company was brought public.

The next highest-ranking executive is President, Residential Segment Jonathan Skelly who was promoted to that role in July 2022 after working as SVP, customer experience for a year. Skelly joined AZEK as SVP of strategy and execution in 2018 and held that title until 2021. He was previously with W.W. Grainger as VP of corporate development and was also director of strategic business development for Home Depot (HD), giving him good industry experience.

Compensation and Incentives: AZEK pays out compensation in the form of a base salary, annual bonuses paid in cash and long-term compensation that 50% in performance-stock units (“PSUs”), 25% in restricted stock units (“RSUs”) and 25% in stock options. There’s also sporadically been bonuses that are separate of the annual bonus for special purposes, such as guiding AZEK through the IPO. The typical pie chart provided by the company is below. It shows the CEO’s pay is 61% from long-term pay (PSUs, RSUs and options or total SBC). That percent has been on target for Singh. It also shows other executives had 42% of their pay in stock and my table below shows it’s generally been higher with an average of 61% for the select top executives.

A glance at the table shows some particularly high values for stock awards for executives in 2020, such as $25.0M for Singh and $5.3M for former CFO Nicoletti. That was due to the conversion of pre-IPO profit interest units (“PIUs”). PIUs are common in private equity and for AZEK were converted into common shares if already vested and RSUs if unvested. That means exchanging profits interests for Class A stock didn't quicken vestings. Alongside, recipients of the new shares got options to buy more Class A stock, ensuring they retained their original "leverage" from the profits interests. There was also a vesting of performance shares based on the realization of an exit multiple by the PE companies. The change in terms triggered a compensation expense and the conversion carried a cost of $103.4M (11.5% of revenue).

Next I’ll discuss the performance incentives to the different compensation buckets, starting with the annual bonus. Annual bonuses at AZEK have a target amount tied to the executive’s salary. For CEO Singh, CFO Clifford and Unit President Skelly, the amounts are 110%, 75% and 50%. The payouts are based on performance weighted 50% to adjusted EBITDA, 25% to net sales targets, 15% is weighted toward individual pre-established performance goals and 10% is based on individual contribution to achievement of ESG goals. The individual performance is fairly qualitative while 75% is quantitative by attaching it to adjusted EBITDA and revenue.

In order to get a 100% payout for the annual bonus for fiscal 2022 financial performance, AZEK needed to achieve $1,373.5M, which was 97.4% of the sales guidance given for 2022 in November 2021 (when AZEK reported fiscal Q4’22 results). Achieving the threshold amount yields a 50% payout of the target, the target means the executive gets 100% of the bonus pay and the maximum is capped at 200% of the bonus pay. The table below looks at the targets set out versus the guidance at the start of the year. I’m good with management getting their bonuses paid in full if they simply meet the guidance sheet. I listed actual performance as well, given in the proxy, which takes out performance from acquisitions. Also note that President, Residential Segment Skelly had performance goals strictly tied to the residential segment.

As a comparison, Trex’s annual cash bonus was weighted 75% based on the achievement of a pre-tax income target and 25% weighted toward a target of operating cash flow. Both of these figures are adjusted for “extraordinary” items. For instance, in 2021, the pre-tax income target excluded the write-off of goodwill of Trex’s Commercial Products because it was “not anticipated in the financial plan”. Sounds like some poor governance if you ask me. In any case, it’s notable that Trex has all of the annual bonus tied to profit-like performance whereas AZEK has 50% tied to a profit-like metric, 25% growth and 25% qualitative individual goals.

Next in the compensation program is long-term incentives (stock-based compensation). AZEK sets a total dollar value then pays out that amount with 25% in time-based RSUs, 25% in options that are also vest over time, and 50% paid in the form of PSUs. The PSUs have a three-performance period and are weighted 45% toward a cumulative net sales goal and 45% toward an adjusted EBITDA goal. The remaining 10% is based on the average return on net tangible assets. Target amounts are set and payouts can range from 50% to 200%.

Trex’s long-term incentive program is 35% RSUs, 50% PSUs and 15% stock appreciation rights (“SARs”). SARs are like options though less dilutive. The PSUs similarly have a three-year performance period and the incentive is 100% based on EBITDA targets. Another situation where Trex is more focused on profits rather than outright growth.

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Outlook: AZEK is three-quarters the way through its fiscal year of 2023 as of this writing. AZEK reported fiscal Q3’23 results on August 8 and revenue so far for the first nine months came in at $981.5M, down 6.6% from the first nine months of 2022. The gross profit margin so far this year was 29.3%, down from 32.1% in the first three quarters of 2022. Looking more granularly, growth appears to be coming out of a trough and is rebounding after Q1’23 when revenue was -16.7% lower YoY. Revenue began to decline in fiscal Q4’22 when growth moderated and channel de-stocking quickly occurred. It was evident distributors built out too much inventory post-pandemic when deck building was popular and it needed to be recalibrated. Note that margins have followed this same trajectory of hitting a trough early in the year before rebounding solidly in the latest quarter.

Exterior products remained strong and the over-built inventory was focused in decking and railing products. However, commercial products reverted to negative growth in the first nine months of 2023. The story for commercial products was similar to decking in which channel partners met demand through inventory drawdowns causing AZEK commercial segment revenue to decline.

Residential segment sales was down -4.5% in the first nine months, but up 2.5% in Q3’23 showing meaningful improvement. Commercial segment sales were down -20.6% in the first nine months and -30.8% in Q3’23. Management expects the recalibration of the commercial segment to take two more quarters. Even with continued softness in the commercial segment, AZEK management expects Q4’23 revenue to grow at 20.3%, which should take the company back to an elevated level.

The following chart shows quarterly YoY revenue changes on a percentage basis. As you can see, the past two quarters approached revenue growth that was flat YoY.

With growth returning at AZEK there’s a lot to be excited about and it appears AZEK will be on track to again grow organically at a low double-digit pace. Last year, AZEK laid out a 2027 sales target of $2.3B which will be achieved by growing at 10% organically.

In order to achieve 10% organic company-wide sales growth, the residential segment will need to grow at 11% annually. Management expects 4% to come from remodel and repair, 2% - 3% to come from growth initiatives like new product and 3-4% to come from wood conversion.

The wood conversion component has been a boon to composite deck makers in the past five years. According to Principia and company estimates, the composite decking made up just 3% of total decking sales in 1998. By 2015, that number was above 17%, then accelerated higher beginning in 2018 as the following graphic from AZEK shows. Each 1% increase in market-share of composite decking of the total decking adds 4% in annual growth to the composite decking market. That indicates AZEK is forecasting composite decking adds another 1% annually each year over the next five years.

In fact, AZEK is ultra-bullish on the long-term market-share of composite decking by saying the 10 - 15 year opportunity is 50% market-share, up from the ~25% currently. The long-term opportunity is 75%. Both are possible, though the gap in cost of composite decking to wood would have to narrow.

The last topic within outlook I’ll discuss is the opportunity for margin expansion. Adjusted EBITDA margins have been about 22% since 2020. AZEK management plans on getting to 27.5% by 2027. A large portion of that is better recycling to help out the costs of PVC decking and trip, in addition to product design, operating leverage and other optimizations.

Quarterly adjusted EBITDA jumped to 25.0% in Q3’23 after briefly sinking to 7.0% in fiscal Q1’23. CEO Singh said of margins on the August 8 earnings call:

We meaningfully expanded our margins within the quarter as we realize the benefits of cost and sourcing actions and more normalized production levels versus the first half of the fiscal year when we aggressively reduced our production to draw down inventory in our channel and within our own walls.

In addition, we were challenged with having to work through higher cost inventory on the balance sheet that mask the cost reductions that we had already implemented. We expanded our adjusted EBITDA margin sequentially by 570 basis points and year-over-year by 310 basis points. Results within the quarter reflect strong execution by our operations team and our current cost structure.

CFO Clifford noted the drivers to improved adjusted EBITDA margins were material deflation, a more normalized production environment and execution against cost savings initiatives. In Q&A Clifford added “the results here in the third quarter and what we expect in the fourth quarter gives us a tremendous amount of confidence that we're not only on track, but exactly where we'd like to be in pacing to hit the 27.5% in 2027.”

Valuation: I put together a DCF model to value AZEK. Management guided a mid-point 2023 revenue target of $1,348 and with just one quarter left I don’t have a reason to deviate from that figure. That incudes fiscal Q4’23 revenue growing at 20.3%. The DCF forecasts residential and commercial separately to get a better feel for the business. Residential should end up with about 2.0% growth in 2023 whereas commercial will be about -15.0%. From then on residential picks to 12% in 2024 and 2025 and settles at 10% at the end of this forecast period. Commercial increases through 2025 and settles at 4.0%.

I forecasted these growth figures based on the historical performance and it appears there’s still upside with continued wood conversion. This still puts AZEK well below their 2027 goal of $2.3B in revenue, though after a rough 2023, it’s too much ground to make up in my opinion. The five-year CAGR through 2027 would be 8.2% when including fiscal 2023. That follows a five-year company-wide CAGR of 18.8% in the prior five years. Breaking that down further, residential has been at a CAGR of 16.5% since 2016 (including some M&A) and commercial has been at 6.0% since 2016. Investors can even look back on AZEK’s predecessor company for long-term performance of commercial business which clocks in at revenue CAGR of 4.3% since 2007. The residential segment has transformed so much that long-term growth in revenue isn’t a relevant figure.

I’m projecting EBITDA margins of 23.5% in 2024 and then continue to move higher to 26% in 2027, which aligns with management’s adjusted EBITDA target of 27.5% (about 1.5% is SBC).

Capital expenditures are expected to be $85M in fiscal 2023. This follows an average of 10.5%, which I’d consider elevated for AZEK. The DCF model plans for 8.0% of revenue going toward capital expenditures. Cash flow projections are as follows.

The other critical inputs of the DCF model are the discount rate which is 10.9% based on a beta of 1.8 and the current 5-year risk-free rate of 4.4%. AZEK’s average trailing EV/EBITDA multiple in its short trading history is 35.4 and the median is 26.5. That includes a fairly high multiple in 2020 and 2021. This DCF will exit at 18X. The summary is as follows, which calculates a fair value of ~$42.50, roughly 31% higher than the current price.

Another way to look at AZEK’s current valuation is a relative multiple to Trex. Here I’m showing the forward EV/EBITDA multiple via Koyfin. As you can see, Trex has almost always traded at a premium. Trex is a good company but I gap in valuation multiples seems too big given Trex is at 23X next twelve months EBITDA while AZEK sits at 15X. Part of the lower multiple for AZEK may have to do with having a slower growth commercial business that makes up 12% of company-wide sales. By my estimates, commercial will make up less than 10% of sales in 2026 as the business is increasingly made up of the faster growing residential products.

Higher valuation multiples generally come with higher growth. In the revenue forecast screenshot I noted that the sell side estimate for 2024 is $1.47B (8.9% YoY growth) and is $1.58B (7.5% YoY growth) for 2025. By comparison, sell-side analysts are more bullish on Trex by estimating 11.1% growth in 2024 and 12.7% in 2025. This is a bit surprising to me. If I was to place a bet on better growth prospects it’d be on AZEK.

Conclusion: AZEK is a well-managed maker of composite decking and exteriors that continues to have a tailwind as more buyers shift to composite materials from wood products Conversion from wood was strong in the past five years and there’s solid runway left that could make for strong cash flow in the next five years. I like that AZEK has some diversity to its business with exterior trim and siding balancing out the decking business. AZEK’s commercial business further broadens the revenue streams. In addition, there’s likely some extra demand for shares based on the ESG considerations. Shares have experienced a strong rally in the past three months with shares up 37% to ~$32.00. There’s some upside in shares left for those with a long-term horizon though I’d prefer to wait for a pullback if possible given the DCF’s fair value estimate of ~$42.50.

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Disclaimer: This is not advice to buy, sell or hold any stock referenced. Do your own due diligence. I have no position in any stock mentioned in this report. Like any financial analyst, doesn’t mean I’m not biased.

Overview: Encore Wire manufacturers electrical wires and cables that are used to distribute power from transmission grids to the end-use at a wall outlet. The products are driving an economical transition to a more sustainable infrastructure through electrification — the act of converting infrastructure that was previously fueled by non-electric power into electric. This includes cars that were internal combustion or grids powered by fossil fuels such as coal. The conversion and Electrification of Everything is acting as a meaningful tailwind for Encore.

Electrical wires are mostly copper, and so the business of Encore is heavily tied to the commodity price. Some investors don’t like investing in commodity-tied companies. The price of copper is unpredictable and there’s less control of management on the profit compared to a lot of other industries. Encore Wire is a unique company with lots of peculiar attributes so even if you don’t like commodity-tied company, Encore still makes for an interesting company to read and learn about.

Their strategy is focused on utilizing its unique delivery model in which products are produced from a single, vertically integrated campus in Texas that is matched with exceptional customer service. The single-campus model is considered a competitive advantage to Encore by enabling low-cost manufacturing and administrative efficiencies. Generally single-campus models are prone to risks such as scalability, vulnerability to supply chain disruptions and geographical limitations. However, Encore says its single campus approach has combatted most of that by optimizing raw material usage and provides agility. Many companies experienced supply chain disruption from 2020 to 2022 and those in the building materials and infrasture industries were not immune. Encore emphasized its single-campus model in the 2023 10-K by breaking out a new section and saying it has been resilient to supply chain issues experienced by others.

Customer service has also been a key driver to success which has been earned through industry-leading order fill rates. This has been helped by holding broad and deep inventory on hand. My view on the exceptional customer service that Encore touts really means faster order fill rates. When it comes to electric wire, customers want cheap and fast, rather than focusing on brand recognition. Encore strives for just-in-time delivery with orders shipping in 48 hours or less.

Encore Wire’s product line consists of various types of electrical building wire, used in different scenarios from residential to commercial applications. This assortment includes NM-B cable, UF-B cable, THHN/THWN-2, XHHW-2, USE-2, and other types such as SEU, SER, Photovoltaic, URD, tray cable, and metal-clad and armored cable. If you’re unfamiliar with electric wiring, those products types will seem foreign. Explaining each type is unnecessary, but for general knowledge the names explain the type of cable, whether made with either copper or aluminum, insulation material, conductor type, and intended use. This diverse offering positions Encore to effectively cater to the varied needs of customers across different sectors and circumstances. Encore provided its primary product line and I compiled the graphic giving an explanation of each.

Overall, these products are commodities that are hard to differentiate. Encore has put his foot forward with innovation by pioneering the widespread application of colored insulation for commercial and residential cables, enhancing safety and installation efficiency. Encore touts its unique and patented SmartColor ID® in which metal-clad wiring has printed information on the cable that says the size, quantity of cables, ground, color of cables and armor type. Without this sort of ID system, users would need a reference chart or booklet. This makes the wiring easy to identify for inspectors.

In addition, Encore has other creative solutions such as the spool-free PullPro® which is a portable case that makes wires tangle-free and avoids cracks in spools to improve job-site scrap rates. Similarly, the self-spinning Reel Payoff® helps by efficiently pulling cable that saves 74% in labor time, according to Encore. Continuous innovation, evidenced by multiple patents and patent-pending improvements, reflects Encore's commitment to refining processes and enhancing packaging solutions. Note that neither of these innovations is truly groundbreaking and other peers also have colored cable that can be identified and have their own different pull systems and reels.

Encore Wire primarily uses raw materials like copper, PVC thermoplastic compounds, and aluminum in its manufacturing process, with copper being the primary material, constituting 78.6% of raw materials' dollar value in 2022. Prices for these materials are determined by COMEX closing prices for the given month, alongside a negotiated premium. The company also internally manufactures copper rods from copper cathodes and scrap, meeting most of its copper rod requirements. It purchases aluminum rods from various suppliers for aluminum wire production. Additionally, Encore compounds its own wire jacket and insulation materials, producing a significant portion of its PVC needs.

Encore sells its products to numerous wholesale electrical distributers in the United States. Two distributors each made up a little more than 10% of total sales. Distributors then sell to contractors who are the end customer. Distributors in particular strive for lean inventories and therefore Encore looks to carry sufficient inventory itself to satisfy needs.

An effective way to gauge whether too much inventory is building up is the inventory turnover ratio or Days Inventory Outstanding (“DIO”). The metrics are inverse of one another and DIO is expressed in a more digestible form, days, so we’ll look at that here. Last quarter, Encore held its inventory for 32.3 days before selling it. Encore had relatively poor inventory management in 2016 and 2017 when DIO peaked at 45.1 in Q2’16. 2020 supply chain disruptions caused the figure to bottom at 17.4 in Q2’21. Inventories have been normalized since and the Q1’23 Days Inventory Outstanding was in-line with the 10-year average at 32.3.

Encore Wire effectively markets its products nationwide via independent manufacturers' representatives. The company stores the bulk of its finished product inventory at its service center in McKinney, Texas, but also keeps additional inventories at warehouses across the U.S. to accommodate immediate delivery requests. Goods are usually delivered by truck, with the carrier selection based on cost and availability. Encore directly handles customer invoicing and credit limit determinations, with minimal historical credit losses. Despite reserving a modest $1.5 million for credit losses in 2021 and $0.7 million in 2020, these figures remain significantly low as a percentage of sales, affirming a robust credit management process. Importantly, the manufacturers' representatives do not have authority to set product prices or modify customer credit limits, ensuring the company maintains full control over these key aspects.

Competitors to Encore feature Southwire, Cerrowire, General Cable and AFC Cable Systems. Let’s dig into these companies to analyze where Encore fits in the industry. For context, Encore had 1,672 employees as of December 31, 2022 and generated $3.0B in sales in 2022. Southwire was founded in 1950 and has always been family-owned, so details on them, and most peers, are limited. Their website says they employ more than 7,000 employees while Forbes pegged their 2022 estimated revenue at $8B (up from $5.5B in 2021), making it Americas 66th largest privately owned company. General Cable previously traded under the ticker BGC but was acquired by Italy’s Prysmian Group in 2018 for $3.0B. General Cable had generated $3.8B in sales in 2017 (more than 3X Encore at the time) and employed 8,500 employees. Now General Cable is consolidated in Prysmian financials so it’s unclear exactly how much that business is generating. Cerrowire is a smaller player though again not much is known from a financial perspective as the company is owned by the Marmon Group, a subsidiary of Berkshire Hathaway. Some online sources estimate their revenue at nearly $300M.

Encore names AFC Cable as a competitor, and it’s owned by Atkore International (AKTR). Atkore is also a key player in the manufacturing of electrical products but is more diversified, servicing non-residential, residential, and industrial markets. Their Electrical segment, which generated $3.0B (77%) of $3.9B in total sales in 2022, focuses on constructing electrical power systems using conduit, cable, and installation accessories. Atkore’s product lineup extends to safety and infrastructure items, including metal framing, mechanical pipe, perimeter security, and cable management solutions, thereby serving contractors, OEMs, and end-users. They aim to adapt their offerings to meet changing customer needs and industry trends, including digital design tools and labor-saving solutions.

Compared to Encore, Atkore's product portfolio is more extensive, with products not only related to electrical systems but also infrastructure and safety. Both companies focus on innovation, but while Encore's innovations are mostly related to the physical properties of the cables (e.g., color coding and packaging), Atkore's innovation extends to the installation process, making it faster and smoother with products like the MC Glide Tuff armored cable and Eagle Basket.

When you aggregate the named competitors there’s about $20B in revenue between them, including Encore, meaning the company has a small amount of market share currently. Unfortunately, it’s tough to get a sense of the cost advantage since the two largest players in the U.S. don’t disclose financials. It is likely that the single campus model has helped Encore in recent years to speed up production, an attribute Southwire and General Cable do not have. Peers are either too small to have meaningful supply chain resources such as railway into the manufacturing facility, like Encore does, or they’re very large and spread out. Encore seems to blend both.

Now let’s shift to Encore’s historical results and seeing as the company debuted on the public markets in 1992, there’s a lot to look back on. In the most recent calendar year, 2022, Encore generated $3.0B in sales, up 16.4% YoY from 2021 when revenue was $2.6B. The increase in sales was driven by a 7.9% increase in pounds of copper wire shipped, which was offset slightly by a 0.5% decrease in the average selling price. As mentioned earlier, Encore’s sales are tied heavily to the underlying price of copper. In 2022, the average COMEX closing copper price was $4.00, down 5.8% from the 2021 average of 2021. What’s more closely tied to the underlying commodity price is the average purchase price of copper, which decreased 2.7% in 2022, increasing the spread at which Encore buys copper and sells wire.

While the cost of purchasing copper is close to the commodity price, the average selling price of copper wire can vary, and that’s largely due to market dynamics (basic economics here of supply, demand and competition). That gets clearer looking at 2021 results. In 2021, sales skyrocketed 103% to $2.6B from $1.3B, representing the largest annual jump since the first year as a public company in 1992. 2021 sales were driven by an increase in the average selling price of 84.7% which was coupled with a 10.8% increase in volume according to the copper wire pounds shipped. However, the cost of copper purchased only increased 49.5% that year (much less than the increase in the average selling price), leading to a jump in margins. 2021 was a year in which builders needed copper wire and Encore’s relatively solid supply chain was able to fill orders and mark up the price. The result was the gross profit margin jumped to 33.5% in 2021 after a decade of gross profit margins near ~13%. Gross profit margin inched even higher in 2022 to 36.9%, which is the highest ever for Encore as a public company. In the outlook and valuation section I’ll put some thoughts down discussing where that will go in the future.

When I analyze commodity-sensitive companies, I focus on volume of product more than price as the latter isn’t as controllable. I went through the past 20 10-Ks and extracted both the annual change in pounds of copper sold and average selling price of copper. Encore doesn’t disclose the figures outright (instead giving an annual percent change) so I indexed the change back to 2002 and created the following table and chart. Through 2005, Encore maintained a streak of year-over-year increases in unit volume according to pounds sold. Four years later, in 2010, volume reached its trough then steadily recovered before accelerating higher in 2021. Overall the growth in pounds shipped grew at an average annual compound rate of 2.0% since 2002 and 3.5% in the past 10 years. Copper prices were very strong in the 2000s then flatlined from 2011 to 2018. Overall Encore’s average selling price has grown at a CAGR of 9.7% since 2002 and 7.5% over the last decade since 2013.

Cash flow has historically been volatile due to the varying prices of copper and management has responded by conservatively operating Encore with no debt. In fact, Encore hasn’t carried debt since 2010. In the next section I’ll review how Encore spends it money.

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Capital Allocation: The broad ways a company can spend their cash is capital expenditure to maintain and grow the existing business, growth via acquisitions, dividends or buybacks. Encore has exhibited a unique strategy of not spending on M&A, instead cash flows have mostly been spent on building the business organically. It’s common for companies to try to grow through acquisition. CEOs often have an itch for empire-building and a lot of resources are spent pitching acquisition targets to management from investment bankers looking to make money themselves.

As a comparison of the capital allocation at Encore, the graphic below includes Atkore. Starting with Encore. The business has generated $1.6B in cumulative cash flow from operations over the last 10 years (2013 - 2022). Of that, 38.5% was spent on capital expenditures. 19.2% was spent on buybacks, with most of that in the past three years. Dividends were negligible at 1.0% of operating cash flow. As mentioned, no cash was spent on acquisitions and there weren’t any divestitures either. Combined, that means about 40% of the cash generated wasn’t actually spent, and since Encore has no debt, the cash has simply accumulated.

During the same 10-year period, Atkore generated $2.5B in cash from operations. The capital allocation priorities were more balanced and typical with the company spending 18.3% of its cash generated on acquisitions, net of divestitures. 16.6% went toward CapEx and 55.1% went to buybacks. Atkore never paid a dividend. Buybacks were driven higher in 2018 when it bought back nearly 30% of its outstanding shares from its private equity sponsor, Clayton Dublier & Rice (“CD&R”).

Back to Encore, which ended 2022 with $730.6M in total cash and cash equivalents, a figure that decreased slightly as of Q1’23 via continued elevated buybacks. That means at the last reporting period (March 31) Encore had about $39 per share in cash, or about ~20% of the stock price. When discussing capital allocation priorities in August 2022, CFO Bret Ekert said:

Given today's volume and raw material requirements, just to kind of baseline, I believe we need to keep roughly $200 million of cash on the balance sheet for working capital needs. It's on the fringes where you're going to need cash, $2 copper, $8 copper, right, is where you're going to really draw in your cash balances.

As I said before, we continue to have 3 primary uses of cash. We've got capital expenditures, we've got share buybacks, and we've got a dividend. We've grown organically from day 1. We've never done an acquisition. We've got 460 acres, and we sit on 220, 225 of them. So we've got a lot of room for growth right here on this vertically integrated campus.

We just discussed CapEx levels -- CapEx level. And I'd tell you we're likely tapped out for the next 3 years with the current initiatives that we have. We did repurchase 1.1 million shares year-to-date in 2022 for approximately $132 million. Since February of 2020 through the second quarter of '22, we purchased just over 2 million shares for a total cash outlay of $196 million.

So I would tell you some new news or current news, the Board, as you know, had previously authorized the repurchase of 2 million shares in March 31, 2023. We have repurchased, as I said, $1.1 million year-to-date on that authorization. The Board has reloaded that authorization back up 2 million shares through March 31, 2023. We continue to see this as a good use of cash. We do discuss the highest and best use of company resources with the Board every time we meet, and we're going to continue to evaluate those options on a go-forward basis.

More recently, on the April earnings call, Eckert added this comment in regards to capital expenditure spending.

Capital spending in 2023 through 2025 will further expand vertical integration in our manufacturing processes to reduce costs as well as modernize select wire manufacturing facilities to increase capacity and efficiency and improve our position as a sustainable and environmentally responsible company. Total capital expenditures were $148.4 million in 2022 and $31.8 million in the first quarter of 2023.

We expect total capital expenditures to range from $160 million to $180 million in 2023, $150 million to $170 million in 2024 and $80 million to $100 million in 2025. We expect to continue to fund these investments with existing cash reserves and operating cash flows.

Connecting the two statements that management would like to have about $200M (maybe $250M now) in cash and plans to spend $420M on capital expenditures in the next three years, combines to nearly $700M in cash usage. For what it’s worth, maintenance CapEx is about $60M annually. Given the current cash pile, and ongoing cash flow, there’s still a lot of room for buybacks, which could be equal to all of the cash flow from operations in the next three years.

Management and Incentives: CEO Daniel Jones joined Encore in 1989 as director of sales. He was promoted to COO in 1997 and added the president title in 1998. Jones initially took on the CEO role on an interim basis in 2005 then was named permanent CEO in 2006, a position he’s held since. Despite having served as CEO for 17 years, Jones is currently 59 years old, so there’s a little runway left.

Bret Eckert joined Encore in his current role as CFO at the start of 2020. Eckert spent the first 22 years of his career at Ernst & Young where he worked with Encore by auditing the company for five years. He then shifted his career with his first CFO role at Atmos Energy (ATO) from 2012 - 2017. In between Atmos and Encore, Eckert worked in consulting.

Generally for industrial companies the third-ranking executive is the head/chief of operations. For Encore, that’s William (W.T.) Bigbee whose title is VP of operations. Bigbee started his career as a process engineer at peer company General Cable from 1989 - 1998 then shifted to Encore and worked as VP product and research development before promotion to VP of operations in 2016. Given the hierarchy, Bigbee seems to be a suitable candidate to succeed as CEO. Eckert is also a CFO who is highly involved and is another candidate to become CEO. What I found unusual is that Bigbee isn’t a named executive in the proxy; only CEO Jones and CFO Eckert are named executives and therefore have compensation detailed in the proxy. It’s unusual for an industrial company with a ~$3.0B market cap to have only two named executives. When looking at the count of insiders, which is a different threshold than being a named executive for proxy compensation rules, Encore has three insiders with the inclusion of Controller Matthew Ford. To put that into context, Russell 3000 companies have a median of six executive officers. Industrial Goods companies (the sector Encore is in) have a median of seven. This is yet another example of how Encore is an outlier company.

Now shifting to compensation. In 2022, 6.3% of Jones’ total compensation came from salary, 35.8% came from his annual cash bonus and 57.6% was paid in the form of stock awards. Eckert’s compensation split was similar. For each executive the amount total compensation paid in the form of a base salary was unusually low compared to the prior five years and the amount paid in the form of equity was unusually high. The table details compensation.

Encore’s at-risk compensation is split between annual cash incentive (cash bonus) and stock awards paid out as RSUs. Both are highly qualitative in nature compared to the norm which is to tie compensation to defined targets (such as revenue growth or profit margins). Encore says “Our bonus payouts are highly variable based on Company and individual performance.” The amounts are determined based on each executive officer's contribution to the company's performance of key objectives and profitability. The company believes that profitability is one of the most effective measures of management's efficiency in creating value for the company's stockholders. Therefore, Jones and Eckert saw significant rises in bonus pay in 2021 and 2022. Jones’ bonus was $6.0M, or about 6X his salary, and Eckert had a similar multiple of salary. Given that high multiple, there’s apparently no cap to the bonus payout (common example 200% of salary).

The stock award component, which is purely RSUs (time-based vesting), are given in connection with each executive officer's efforts and performance in the preceding fiscal year. The amount of equity granted to officers is determined by considering the individual's position, scope of responsibility, ability to influence profitability, the individual's performance, and the value of stock awards in relation to other elements of total compensation. The company's profitability, compared to historical results and recent peer group results, is also taken into account when determining the number of equity awards to be granted to officers. “The equity awards granted in January 2022 were made in connection with each named executive officer's efforts and performance in fiscal year 2021.” Compensation programs don’t get simpler than that. A qualitative judgment of the amount of equity to dole out with a time-based vesting scheme rather than more complex performance stock units that vest according to financial and/or stock performance. I personally prefer specific metrics tied to the compensation plan and would advocate Encore provide a more clearly defined and quantitatively-driven compensation plan. Generally, as a shareholder, I like to clearly know if management is incentivized with compensation tied to increasing revenue, profit or perhaps boost the stock via total shareholder return targets.

Outlook: Most of the overview section focused on Encore’s history from 2003 - 2022. Stocks are valued on what they can do in the future, not what they’ve done in the past. And most recently, in Q1’23, Encore reported its first quarterly revenue decrease on a year-over-year (“YoY”) basis after 10 straight quarters of growth (Q3’20 - Q4’22). For Q1’23, revenue dropped 8.7% driven by a flat quarter of volume change and an 11.8% decrease in the average selling price of copper (nearly matching the 10.3% drop in the COMEX average daily close in Q1’23 against Q1’22).

Encore doesn’t give guidance but I’ll note the Wall Street consensus expectation calls for a -6.0% YoY change in revenue in 2023. Moreover, EPS is expected to decrease -37% in 2023 as analysts forecast a drop in profit margins.

I can’t predict where copper will go in the near-future, and I’m not a short-term investor looking to game out earnings beats and misses (Encore does report earnings after the bell on July 25 by the way). However, I can lay out the narrative for the long-term, which is a meaningful secular tailwind of “Electrification of Everything”.

The Wall Street Journal posted a May 2021 articled title The Electrification of Everything: What You Need to Know that’s worth reading. The article links back to a Princeton University study examining that electrifying nearly all transport and buildings would double the amount of electricity used in the U.S. by 2050. The study also “estimates the country will need between double and triple today’s electricity transmission capacity to accommodate the Biden administration’s goal of achieving net zero greenhouse-gas emissions by 2050.” The Journal also had these quotes:

In California, electric heat pumps are gaining traction as more than 26 of the state’s counties and cities have enacted bans on natural-gas hookups in new construction. Other places have done the same, and there’s no doubt many others across the country will follow…

If we’re going to rely much more on electricity, we need to know the grid isn’t going to break down. Right now, we don’t know that, even for today’s level of demand. Sections of today’s grid were built in the 1950s and 1960s and are approaching end-of-life conditions. The 2019 wildfire crisis in California, for instance, highlighted how much of PG&E’s thousands of steel electricity towers needed to be repaired or replaced.

The Inflation Reduction Act that was signed into law in August 2022 includes funding of $7.5B to make electric chargers more accessible to Americans, in addition to extending tax credits for buying electric vehicles. When asked about the impact of the Inflation Reduction Act on the April 2023 earnings call, CFO Eckert responded:

It really gets back to what you all think about the continued expansion of data centers and what AI might do to that and what you think about renewables in this country, look at EVs, right? 1% of the vehicles in the U.S. are electric, right? But to get to that, you've first got to build battery plants.

You've got to build the facilities to build the cars. You need more semiconductors. And so you've got to build semiconductor plants, all that takes wire and cable. And then once you get the electric vehicle, the electric vehicle charging capacity in the U.S. is not great. right?

The majority of a charging station is copper. You power it with aluminum. And so a lot of the things with regard to the infrastructure, the hardening of the grid and the electrification is all going to take wire and cable with a looming supply gap in copper -- headed out there in the next 3 to 4 years. And so those are the constructs that we look to when we look for capacity additions and where we want to build in the market.

Encore covered The Increasing Call on Copper with the following slide in its March 2023 presentation titled Electrifying the Future. There’s a lot of information here. A few points to make note of is the amount of copper used for electricity generation of renewable energy versus non-renewable (3X the amount and higher); copper used for electric vehicles versus ICE cars; global copper demand’s continued trajectory higher and lastly the copper deficit.

Encore Wire referenced S&P Global’s July 2022 on the Looming Copper Supply Shortfall. Banning natural gas to heat homes and stove tops, the shift to electric cars and the charging stations that come with them, and shifting to more renewable energy via wind and solar all are causing a deficit in copper. Here’s a snippet via S&P Global:

Under current trends—whereby both capacity utilization and recycling rates remain at their current 10-year global average—the study's Rocky Road Scenario projects annual supply shortfalls that reach nearly 10 million metric tons in 2035. That is equivalent to 20% of the demand projected to be required for a 2050 net-zero world.

Even under the study's optimistic High Ambition Scenario—which assumes aggressive growth in capacity utilization rates and all-time high recycling levels—the copper market will endure persistent supply deficits through most of the 2030s, including a deficit of nearly 1.6 million metric tons in 2035—much higher than any previous shortfall…

Such a supply gap would have broader consequences across the global economy, disrupting supply chains for both energy transition and non-energy transition industries, the study says. Given copper's use in a wide range of end markets, it would also exert tremendous upward pressure on the cost of goods for global manufacturers as well as energy costs for consumers.

Taken together, the Electrification of Everything movement and projected copper deficits indicate over the next +10 years the price of copper has an upward trajectory. The chart below shows the price of copper in tons dating back to 1992.

The next chart shows the performance of Encore shares plotted against the price of copper. Encore shares have decoupled from the price of copper in the last two years. Looking back further and it’s clear Encore shares haven’t been strongly correlated with the commodity price as profit is driven by the margin in buying copper and selling the wire.

The Electrification of Everything secular tailwind is meaningful for Encore and secular stories like that provide compelling investment theses. At any point in this type of secular cycle, you’ve got ask why is now a good time to invest and how much runway is left. Let’s examine that question in the next section.

Valuation: In order to value Encore shares, I created the following DCF model. Starting with revenue growth of -6% in 2023 which essentially matches the sell side analysts’ consensus estimate. However, each year after the model forecasts more aggressive growth than the street. A rebound in 2024 seems achievable given the jump in housing starts late in Q2’23 and it’s reasonable Encore can grow at 3% - 4% annually after with the Electrification of Everything movement. Overall the five-year period is a CAGR of just 1.5% for sales. That compares to a CAGR of 11.4% from 2003 - 2022 and 11.2% from 2013 - 2022. On a more bearish note, revenue growth was flat from 2006 - 2020 so the 20-year CAGR figures are helped by the early 2000s and 2021/2022.

I’m forecasting margins contract back toward the historical norm which had been around 10% for EBITDA for the last 20-years. Year five of the DCF has EBITDA margins at 15%. It’s hard to believe Encore can maintain the unusually high profit margins. Encore and other electrical wire manufacturers have been building out capacity. For Encore in particular, they added 15-20% in capacity late in 2022 through the addition of a repurposed manufacturing facility (plant 7). When manufacturers add capacity it’s easy for margins to compress after.

Recall that CFO Eckert providing CapEx forecasts for the next three years of $170M, $160M and $90M in 2023, 2024 and 2025 (mid-point). The prior five years had CapEx equal to 4.5% of revenue so for 2025 and beyond I picked percentages close to that figure. The following shows the calculations of free cash flow.

The exit multiple for the DCF is 8.5X EV/EBITDA (TTM), which matches the average of the last 10-years and close to the last 20-years. Encore has no debt so the capital structure is currently 100% equity. The 10.5% discount rate is therefore driven by a beta of 1.3, and equity risk premium of 5.0%.

The following calculates a fair value $239 based on the above-mentioned inputs, indicating upside of ~38% presently. However, I’ll note that if EBITDA margins instead gradually fall down to 10% by year five, the DCF implies 0% upside. At that point, it appears the market is pricing in that margins revert back to the norm. It becomes a reverse-DCF. I view that more closer to the bear case (with the addition of lower growth). The bull case would be copper prices charge higher in the next five to 10 years and Encore grows meaningfully more than the base case I’ve presented.

Summary: Encore has a simple and easy-to-understand business model that has edge through its cost-effective single-campus model and efficient just-in-time delivery. With a 10-K that’s just 42 pages, Encore is digestible and has many attributes that Warren Buffett would like. The business has compelling secular tailwinds as the U.S. ramps up the Electrification of Everything. Given the upside of nearly 40% implied through the DCF, I will stamp Encore shares with a Buy. Investors would need to have a long-term investment horizon in order to initiate a position in a commodity-type stock while growth slows.

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Disclaimer: This is not advice to buy, sell or hold any stock referenced. Do your own due diligence. I have no position in any stock mentioned in this report. Like any financial analyst, doesn’t mean I’m not biased.

But Zebra's offerings go far beyond hardware; they produce powerful tools that help businesses meet key goals such as ramping up productivity, adhering to regulatory compliance, and delivering outstanding customer experiences. Imagine a warehouse where every package, each piece of equipment, every worker, robot, and even customers in a store or patients in a hospital, are digitally connected. This level of connectivity gives businesses the power to know the status, condition, location, usage, and even preferences of their assets at any given moment.

Zebra has also been building out its software offerings. Not only do they make and sell a wide range of AIDC products, they also deliver related software applications. And to ensure their customers are never in a bind, they offer a full range of services, including maintenance, technical support, repair, and managed services. They also have cloud-based software subscriptions and robotic automation solutions up their sleeve.

Zebra has been leading a shift from the traditional AIDC market into what they term "Enterprise Asset Intelligence" (EAI). With EAI, Zebra aims to make their solutions sense more, analyze more, and act more effectively throughout their workflows. Think of it like a detective novel where the clues are gathered (sense), pieced together (analyze), and then acted upon to ensure the best outcome (act).

Fueling this evolution is a strong undercurrent of technology trends, including the Internet of Things (IoT), cloud-based data analytics, intelligent automation, mobility, computer vision, and AI and machine learning. Thanks to IoT, Zebra's solutions can connect a growing number of smart devices, allowing for a real-time exchange of a vast array of information. With machine learning and AI, Zebra is stepping beyond mere data collection; they're analyzing it in real-time to provide actionable insights.

Moreover, the expansion of mobile devices and application software is dramatically expanding mobile computing use cases across enterprises and supply chains. This means businesses can access and act upon dynamic data anytime, anywhere. Zebra’s technology is being enhanced by computer and machine vision technology – essentially giving their solutions the ability to "see" and understand digital images or videos that keep them up to date with AI trends and provides another layer of intelligence to their toolset.

Segment Analysis: Let me break down the reportable segments to dive deeper. The first of two segments is Asset Intelligence & Tracking (“AIT”) that includes barcode and card printing, supplies and services. The second is the Enterprise Visibility & Mobility (“EVM”) segment which includes mobile computing, data capture, machine vision, services and workflow optimization solutions. AIT made up 30% of 2022 sales while EVM made up the remaining 70%.

Asset Intelligence & Tracking (“AIT”): Produces high-quality, on-demand printers for labels, wristbands, tickets, receipts, and plastic cards, catering to a multitude of applications requiring data accuracy, speed, and reliability. These printers use thermal technology and support various communication protocols, making it so they can integrate into most computer systems. AIT also includes the production and sales of customized thermal labels, receipts, ribbons, plastic cards, and RFID tags, and provides various maintenance, technical support, and repair services, including cloud-based subscriptions. Zebra has a lot of content on their website and if you want to read more on the products check out their solutions and offerings. It includes brochures on products such as RFID. Of the $1,736M in sales AIT did in 2022, $95M (5.5%) was services and software, indicating nearly all of the segment was tangible products.

Zebra provides segment level results for AIT and EVM. The following table strings together multiple 10-Ks to understand the trends over time for AIT. GAAP net sales and organic sales growth have been solid at a compounded annual growth rate of 5.6% since 2016. Sales lagged in 2020 as customers pushed off purchases, but made up for it with 19% organic growth in 2021. 2022 essentially moderated back to the norm. I’ll also note that margins have deteriorated over time with gross margin bottoming in 2022 at 43.0% and operating margins similarly at a multi-year low of 20.7%.

Enterprise Visibility & Mobility (EVM): manufactures and sells enterprise-grade mobile computing products and accessories for various enterprise applications. These devices support local-area and wide-area voice and data communications and include features like barcode scanning, GPS, RFID, and other sensory capabilities. Specialized features like advanced data capture and analytics technologies further enhance efficiency.

The EVM segment also designs and manufactures barcode scanners, RFID readers, industrial machine vision cameras, and fixed industrial scanners. These scanners are used in diverse applications, from supermarkets to hospitals, and can handle linear and two-dimensional barcodes.

EVM offers comprehensive maintenance, technical support, repair services, and managed and professional services for their customers. It also provides cloud-based subscriptions and workflow optimization solutions, including software-based solutions, retail solutions, and robotic automation solutions. These solutions aim to improve agility and productivity, mainly focusing on frontline workers in core customer segments.

Lastly, their Location Solutions provide precise, real-time information about the location and status of high-value assets, equipment, and personnel, using technologies like RFID and beacons. They cater primarily to manufacturing, aerospace, transportation and logistics, sports, and healthcare industries.

Similar to AIT, the table below provides a breakdown of segment level results for EVM. First starters, EVM has been growing quicker than AIT. In 2022, EVM made up nearly 70% of company-wide sales, up from 65.4% in 2016. The growth in that period was 8.9% annually on an organic basis and 9.6% on a GAAP reported basis. The difference is organic excludes foreign exchange, acquisitions and divestitures. Acquisitions added incrementally to sales for EVM. Unlike AIT, margins have improved since 2016. Gross margins of 46.4% in 2022 is up 2.3% while operating margins are up 7.1%. The last segment note is that EVM has solidly higher revenue stemming from services and software at 19.1% in 2022, which has steadily risen.

It’s important to analyze deconsolidated results to further understand drivers of the business. For Zebra, you can see the largest segment is growing quicker and performing better. The company-wide financial highlights for the past seven years includes an 8.3% compounded annual growth rate (“CAGR”), steady gross margins at 45% and operating margins that have held steady despite some volatility.

As noted while discussing the AIT segment Zebra had relatively poor performance in 2020 as it dealt with poor demand, which was more pronounced in AIT compared to EVM. That was followed by unusually strong growth in 2021 when sales grew 23.2% organically. Zebra said in the 2022 10-K:

Total Net sales increased $1,179 million or 26.5% compared to the prior year primarily due to broad-based customer demand to digitize and automate their businesses. Net sales growth across both of our segments and all of our regions included pent-up demand from customers who we believe had delayed purchases in fiscal 2020 due to the COVID-19 pandemic. In addition, Net sales for the prior year included the negative impacts of supply chain disruptions within our EVM segment resulting from the temporary closure of a key distribution center supplying the Americas late in the first quarter.

You can also see in the following table that gross margins dipped in 2022 while operating margins dropped more substantially that year. The 1.3% drop in gross margins stemmed from higher freight and component costs. The operating margins were dealt a blow due to a litigation that was settled against competitor Honeywell (HON) in which Zebra paid $372M, inclusive of legal fees. If you exclude that, operating margins would’ve been 15.5% instead of 9.2% with the former in-line with recent years.

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According to the 10-K, Zebra says it operates in a competitive industry with growth driven by factors such as IoT, cloud computing, automation, and mobility. Key competitive aspects include product quality, price, design, performance, availability, and brand reputation. In mobile computing, rivals include Datalogic, Honeywell (HON), and Panasonic. In data capture and machine vision, they compete against Datalogic, Honeywell, Newland, Impinj (PI), Cognex (CGNX), SICK, and Keyence. In printing, competitors include Fargo Electronics, Honeywell, Sato, Toshiba, TSC, Brother, and Dymo. The supplies and workflow solutions sectors has numerous global competitors.

In discussing competitive strengths, Zebra has a sub-section titled “High barriers to entry”. The title got changed from “High entry and switching barriers” in 2023 which makes you wonder if there’s a difference in switching costs now. The section itself was unchanged in saying:

“On a global basis, we have long-standing relationships with end-users and with our extensive network of channel partners. We believe these customer relationships and our strong partner network are critical to our success and would be difficult for a new market entrant to replicate. We believe a significant portion of our products and solutions are deployed with specialized product performance and software application requirements, which could result in high switching costs.”

Other competitive strengths include commitment to innovation and deep industry-specific expertise, highly diversified business mix, global reach and brand and scale advantages.

I’ll summarize comments from research and advisory firm Gartner. The strengths, according to Gartner, are Zebra’s data-driven, agile platform, rich partner ecosystem of over 10,000 partners, and cloud-ready APIs. The cautions were that products may be considered expensive for small and midsize enterprises, complexity-creating underlay architecture and limited healthcare experience as Zebra focuses on retail, manufacturing and warehouse. Nonetheless, Zebra is a leader in the quadrant for Indoor Location Services.

Zebra primarily sells its products and services via distributors, value-added resellers, independent software vendors, direct marketers, and OEMs, and directly to select customers. Some Zebra products are re-sold by OEMs under their own brands. “These relationships are highly valued and allow our products to reach end users in a wide array of industries around the world,” the company says. “We believe that the breadth of our distributor and channel partner network is a competitive differentiator and enhances our ability to compete.”

There’s three customers that each account for at least 10% of sales, and in each case they’re distributors. Zebra doesn’t detail who they are, simply saying Customer A accounted for 20.7% of sales, Customer B accounted for 15.0% and Customer C accounted for 12.8% of 2022 sales. Because they’re distributors, and not actually end users, the customer concentration isn’t a knock on Zebra when considering Porter’s Five Forces (power of customers being one of them).

Capital Allocation: The two closest peers to Zebra are Honeywell and Datalogic. Honeywell is a more diversified business and the overlap between Zebra comes from Honeywell’s Safety and Productivity Solutions segments, specifically Production Solutions and Services, and Warehouse and Workflow Solutions. Those two sub-segments made up $3.96B of $35.45B in sales in 2022 (11.1% of company-wide sales). Nonetheless, it’s helpful to analyze capital allocation — the ways companies spend their money — and compare against another peer. While Datalogic is a close peer to Zebra, for this analysis, I've chosen to compare Zebra to Honeywell because Honeywell is a U.S.-based company, making for a cleaner data comparison as opposed to Datalogic.

Looking back since 2013, Zebra has generated $5.4B in cash from operations, and 11.7% of that went toward capital expenditures, 21.3% went toward buybacks and 106.0% was spent on acquisitions (net of divestitures). Judging by those figures, management has opted to grow the company through M&A. However, most of that M&A value came from a single transaction in 2014. Zebra spent $3.45B to acquire the enterprise business of Motorola in order to offer and end-to-end solution through mobile computing and data capture. The deal caused Zebra’s leverage ratio (debt/EBITDA) to balloon to 9X as it was basically funded through a major debt offering. It ended up paying off for Zebra seeing as FCF per share accelerated higher in the years after and I’ll note the leverage ratio has been normalized at a more comfortable 2X and under since 2019. If you only looked at M&A spend since 2015 it would equal 44.5% of cash flow from operations.

Honeywell has generated $57.3B in cash from operations since 2013. 16.5% was spent on capital expenditures, buybacks made up 49.9% of the spend, M&A was at 18.7% and dividend spend was 37.2%. Comparing the two, Honeywell has clearly been focused on returning capital to shareholders via relatively high buybacks and dividends, especially considering Zebra hasn’t paid a dividend. Zebra management has been vocal about favoring internal growth and external growth via M&A in similar markets and venture investments through Zebra Ventures, an interesting VC investing arm with a website that discusses strategy.

Capital allocation priorities have paid off well for shareholders with FCF per share up 9.8% compounded annually through 2022. That would’ve been 13.7% had it not been for the legal settlement against Honeywell I noted above when discussing operating margins. Of the $372M settlement, $147M was paid in 2022. The full amount will be paid by Q1’24 so FCF will again take a hit this year.

A couple notes beyond the table of data. For starters, Zebra appears more thoughtful with buybacks and has rarely been in the market. Part of that stems from the high debt load post-Motorola acquisition. It’s also because management has been opportunistic by leaning into weakness. Honeywell buys back quite frequently and isn’t opportunistic with execution. The second note in the domain of capital allocation is that spending on CapEx isn’t perfectly comparable. Zebra’s organic investment via CapEx appears low from the cash flow statement. The company includes a subsection within the business description of the 10-K for Research and Development.

The Company devotes significant resources to developing innovative solutions for our target markets and ensuring that our products, solutions, and services maintain high levels of reliability and provide value to end-users. Research and development expenditures for the years ended 2022, 2021, and 2020 were $570 million, $567 million, and $453 million, or 9.9%, 10.1% and 10.2% of Net sales, respectively. Worldwide, we have employed approximately 3,100 engineers and innovation and design experts, who along with contractors, are focused on strengthening and broadening our extensive portfolio of products and solutions.

Looking at Honeywell, the company directed about 4.0% of its revenue towards research and development over the past three years. However, understanding the nuances between CapEx and R&D spend is important when comparing these figures with Zebra's numbers.

CapEx mainly comprises investments made towards tangible assets that sustain or grow a business - think of machinery upgrades or additions in factories. The outlays here are concrete, quantifiable, and thus, comfortably nestled under the CapEx banner on financial statements.

On the flip side, R&D expenditure can be more elusive, and its direct translation into future revenue is often less certain. It encompasses spending on less tangible assets, such as investment in emerging technologies, which often involves costs like engineer salaries. While not as easily measurable as CapEx, these investments are crucial to a tech-oriented firm like Zebra, as they fuel innovation and drive future growth.

By considering this aspect, Zebra's commitment to internal growth becomes more evident. Despite the seemingly modest CapEx numbers, the company's substantial R&D investments show a clear strategic focus on enhancing its tech prowess and expanding its solution offerings. This underscores the importance of viewing CapEx and R&D not as separate line items, but as a combined measure of a company's overall investment in growth and future sustainability.

Management and Incentives: Bill Burns, 54, has been CEO of Zebra since his promotion from chief product and solutions officer in March 2023. Burns joined Zebra in 2015 as SVP, Enterprise Visibility and Mobility (EVM Segment) and chief technology officer. Despite being promoted from within, Burns has held two other CEO roles. He was CEO of data center network services start-up Embrane which was sold to Cisco (CSCO) in 2015. From 2008 - 2013 Burns was CEO of Spirent Communications (LSE: SPT), a London-based publicly traded company. So Burns took over as CEO of Zebra from Anders Gustafsson. Oddly enough, Burns also took over as CEO of Spirent from Gustafsson as he was CEO there from 2004-2007.

While Burns was chief product and solutions officer, he was the second highest-paid executive behind then-CEO Anders Gustafsson, so it’s clearly an important role for Zebra. Joe White was promoted and replaced Burns as chief product and solutions officer, after having served as SVP and GM of enterprise mobile computing. White joined Zebra through the acquisition of Motorola Solutions in 2014.

Nathan Winters, 41, joined Zebra as VP of corporate FP&A then took on the CFO role on an interim basis August 2020 before being named permanent CFO in January 2021. Winters’ career was spent at General Electric (GE) and GE Healthcare (GEHC) where his most recent title was CFO, Global Supply Chain from 2016 - 2018.

The last position I’ll note on the executive roster is Chief Revenue Officer Joachim Heel. Heel has led sales for Zebra since joining in 2014 but changed title to CRO in 2021. Previously, he was VP of enterprise sales at IBM (IBM). Overall, the roster at Zebra feels stable by routinely promoting from within. It’s a nice attribute considering the strong returns over the past decade.

Compensation: Zebra targets that executives base salaries make up ~17% of their total compensation and 8.1% for the CEO role. Short-term incentive compensation (regularly known as cash bonus) makes up 16% of executive compensation while the CEO is again lower at 10.9%. The largest form of compensation is long-term incentive compensation (stock awards) with the CEO at 81% and other executives at 67.1%. The percentage break-down is fairly standard for a technology company and aligns compensation with shareholder value by leaning into stock-based compensation.

The following table shows the dollar value of compensation paid to executives, according to the March 2023 proxy. Gustafsson remained as CEO through March 1 so he was still included in the summary table. Overall, the payouts align with the elements visualized above.

Annual short-term incentive compensation is weighted 30% to net sales, 50% to adjusted EBITDA (dollar value) and 20% Enterprise Asset Intelligence (“EAI”) Index. Those weights have been in place since 2019, the year Zebra introduced the EAI Index component.

The 2023 proxy says the EAI Index sales is “defined as a measure of Zebra's sales of EAI offerings and is based on sales of specific EAI-related solutions”. That isn’t very clear. However, if you go back and look at proxies from 2019 - 2021, there’s a bit more color. EAI Index is “defined as a measure of Zebra's sales of EAI offerings and is based on sales of specific EAI-related solutions, such as SmartLens^®, SmartPack™, SmartCount^®, Zebra MotionWorks^®, Warehouse, Location Solutions and managed services, such as VisibilityIQ™.” Generally these products fit into Zebra’s Intelligent Edge Solutions. In 2022, the EAI Index products made $375M in sales (6.5% of total sales), which follows $283.3M in 2021 for 32% growth. This is while company-wide growth was 2.7%. The 2021 sales growth of EAI Index was 75%, again much stronger than company-wide growth. This indicates management is being incentivized to focus more on a currently small portion of sales that’s growing much stronger than the base and could be a great benefit to Zebra in the longer-term.

Long-term incentive compensation is 40% time-based restricted stock units (“RSUs”) and 60% performance-based stock units (“PSUs”). If you’re unfamiliar, RSUs simply vest while employed and don’t have further metrics involved. At Zebra, PSUs are earned based on a three-year performance period and cliff vests at the end of the three-year period. The performance attributes are 60% weighted toward compound average growth (“CAGR”) in net sales and 40% weighted toward adjusted earnings before interest, taxes, depreciation and amortization (“EBITDA”) margin.

“The Named Executive Officers may earn shares based on Zebra's results for each of the three years in the performance period, or based on Zebra's results as of the end of the performance period, whichever is greater.” That gives more flexibility for executives to achieve the targets through the banking system. Any single year Zebra attains performance, executives earn the PSUs. They can also earn it based on the CAGR amount. So it’s a quasi-three-year measurement period.

I like the construction of the long-term incentive pay by leaning heavily on sales growth while keeping margins in mind at a lower weight. However, the hurdles should be higher. I strung together the last four proxy filings to show that the compensation committee has been selecting sales CAGR rates around 4.0% each year. Zebra has easily beaten that figure and the adjusted EBITDA margin percent targets. Therefore actual payout of performance-based compensation has been high, frequently paid out at nearly 200% (the maximum). The table below shows the target sales CAGR and EBITDA margin goals.

Disclosures in proxies about compensation are almost always backward looking. According to some conference call commentary, the goals for incentive compensation changed in 2023 to include some sort of metric for free cash flow conversion (converting net income into free cash flow). Winters said in the May earnings call “We believe the actions we are taking will enable us to deliver greater than 100% free cash flow conversion as we normalize inventory levels. We are focused on achieving a 100% conversion over a cycle, which is now included in our long-term executive incentive compensation plan.”

Outlook: Zebra’s products are costly and aimed toward large enterprises. Hence it takes a lot of planning to purchase equipment and there’s a long sales cycle. Growth began to slow in Q3’22 when Zebra reported its first quarterly YoY contraction in 2.5 years when Zebra reported a sales decline of 3%. At the time, it appeared supply chain was to blame. “We were unable to fulfill all orders due to supply chain challenges related to persistent component shortages for certain products as well as disruption in the transition to our new North American distribution center in the Chicago area. These challenges led to lower throughput than planned late in the quarter,” said Anders Gustafsson in the November 2022 earnings call. “This, along with orders from some large customers being deferred contributed to the lower-than-expected results.” That was the first time the phrase “deferral” was used in a conference call since 2020 amid COVID-19 challenges and it was fairly questioned by analysts that quarter. It was a surprise negative print considering management had expected 3% growth that quarter. Zebra management guided a flat Q4’22, citing macroeconomic uncertainty, elongated sales cycles and project deferrals. Sales beat expectations in Q4’22. However, guidance for 2023 was at a midpoint of -1% when Zebra initially issued FY23 guidance in February. The graphic below shows the year-over-year percent change in quarterly sales growth.

When Zebra delivered financial results for Q1’23 in early May, the company reduced full 2023 sales growth guidance to -4% (midpoint), or down 3% from the prior guidance issued. That includes a 50 basis point headwind from foreign currency changes (“FX”). At the time, adjusted EBITDA margin for 2023 was expected to be 22%, slightly higher than the 2022 mark of 21.4%. Cash flow for 2023 was expected to be $500M at the time which includes $180M in planned legal settlement payments to Honeywell.

Thinking longer-term, my view is that Zebra returns to form in 2024 and beyond with growth around 7.0%. When I shared the consolidated financial results earlier, it showed Zebra had organic growth of 7.8% since 2017. And that’s a level management is targeting long-term as well. The following is a quote from CEO Burns in the February earnings call and was supported with the graphic below.

The fundamental drivers of our business remain intact. Mega trends, including the on-demand economy, asset visibility, mobility and cloud computing and intelligent automation, provides secular tailwinds for our business. I am proud of the progress we're making in elevating our strategic relationship with our customers. We continue to extend our leadership position in our core business and are gaining traction in adjacent and expansion markets, which have higher growth profiles…I believe we're well positioned to deliver 5% to 7% organic growth over a cycle, with an increasing attractive margin profile as we drive continued traction across our core, adjacent and expansion markets.

The ability to grow at a compound rate of 7% isn’t easy for a company as old as Zebra, especially since they have high market share in their core product base. In order to grow at rates above 4% in the longer-term, it takes high investment in R&D, and that’s what Zebra has done. On June 1, CEO Burns participated in a conference hosted by Sanford Bernstein. He had a couple good quotes that highlight Zebra’s ability to grow in adjacent and expansionary markets.

So think of rugged tablet. I go back 4, 5 years ago, we had no real tablet, rugged tablet portfolio even though we had mobile devices. People wanted to use larger screens. Think of a manager in a retail store, think of somebody doing dock walks inside T&L, they want a larger screen format. We just didn't have a portfolio there…Now we're the leader in rugged tablets. So if we put our mind to something, we can go win share in those markets. They grow at high single digits. So think of RFID technology, think of rugged tablets, optic scanning is in other markets. So flatbed scanning, you see in supermarkets. We weren't in that market at all 7 years ago. Now we're the market leader.

Burns went on to discuss opportunity in adjacent markets and expansionary markets, particularly machine vision, fixed industrial scanning, retail software and autonomous mobile robots. Some of that expansion has and will come from M&A, like the acquisition of machine vision company Matrox in 2022 for $881M and robotics company Fetch for $301M in 2021. Fetch was initially invested in through Zebra’s VC arm which is an intriguing aspect of their M&A reach.

Another conference call quote that caught my ear was the shortening of the replacement cycle for Zebra products. Previously the replacement cycle was roughly five years. An analyst asked in the May earnings call, “coming out of COVID, you put in a ton of assets. And I'm just curious on thoughts on the replacement cycle of that.” Chief Revenue Officer Joachim Heel responded that it’s shortened to three years, implying Zebra could have higher than expected sales in 2024/2025. Here’s the full quote.

The investments we've made over the last few years in customer success have given us a really good insight as to what our installed base is and how our customers are using it. And that has generally revealed to us that the usage cycles have shortened, and that the replacements that are being contemplated now are things that have gone in approximately 3 years ago or even less than that. And of course, we have just launched a brand-new set of our midrange and high-end mobile computers and the value tier was released last year. So those are coming right into that refresh cycle that we're seeing from those customers. And that's another reason why we're quite confident that while these customers are deferring decisions and deployments as we speak, they will have to purchase shortly.

The note about “increasing attractive margin profile“ by Burns stems from the fact that Zebra is finishing up a cycle in which there was higher supply chain cost. Freight costs have been interesting to track, particularly with how much Zebra has paid to ship in the air instead of slowly in ocean freight. The graphic below of excess supply chain costs has been continuously updated in earnings releases. CFO Winters said in the May earnings call.

During the peak of the pandemic or during the peak of the supply chain challenges, we air-shipped all of our printers where historically, we'd ship 80% of those on ocean. So getting that back on ocean is we're on the path of that. And Q2 will deliver about 40% to 60% on ocean.

Valuation: My DCF model starts with 2023 revenue dropping -3%, slightly better than management’s guidance. This is a company that under-promises and over-delivers. EBITDA margin of 20.5% matches the guidance. Keep in mind Zebra gives adjusted EBITDA guidance that removes stock-based compensation which often makes up around 1.5% of revenue. I expect growth to gradually return to the norm of 7% over the following five years and margins to tick slightly higher. I’ll note that my forecast is slightly higher than the Wall Street Consensus numbers that see 2025 revenue at $6.21B.

The build-up to the annual cash flow numbers include the following relevant data points. CapEx at 1.4% of sales annually, depreciation & amortization at 3.4% of sales and a tax-rate at 19% (according to Zebra guidance). I also further reduced 2023 FCF due to “higher cash taxes” this year that are “a bit of a burden”, as CFO Winters said in May.

The other important inputs are the discount rate and exit multiple. The discount is calculated as 10.5% based on a beta of 1.7, an equity risk premium of 5.9% and a debt-to-equity ratio of 79%. I chose a 16.5X trailing twelve month (“TTM”) EBITDA exit multiple which matches the average since 2016. For another reference, I screened on peers in the same electronic equipment industry with similar size and five-year sales growth. The 16-company basket trades at 16.4X right now according to Koyfin. Zebra currently trades at 12.7X, which is on the low side of history. DCF summary shows a fair value of $359.

Summary: Zebra provides a good value-proposition to customers with solid tailwinds, such as modern asset tracking and visibility, intelligent automation and optimizing labor through technology. The business has grown well in the past seven years with organic sales growth near 8% and free cash flow had a great trajectory until 2022. The DCF model’s fair value estimate of $359 implies upside of ~27%. This is a stock that will be on my radar, but I prefer a bit more margin of safety. It could look appealing at $255, which would imply upside of ~40%. Long-term I expect free cash flow to compound nicely through the organic investments Zebra makes annually.

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Disclaimer: This is not advice to buy, sell or hold any stock referenced. Do your own due diligence. I have no position in any stock mentioned in this report. Like any financial analyst, doesn’t mean I’m not biased.

Overview: Thor Industries is the largest recreational vehicle (“RV”) maker in the world that sells in both North America and Europe. Founded 1980, Thor has well-known brands such as Jayco, Heartland and the iconic Airstream. There’s three reportable segments: 1) North American Towables, 2) North American Mortorized and 3) European RVs. THOR also has an “Other” segment made up of RV components and digital assets.

Towables consist of conventional trailers that are towed by pick-ups and SUVs and fifth-wheel style trailers that have a raised forward section and are attached to the bed of a pick-up truck. Motorhomes, as the name sounds, are RVs that are self-powered with their own engine. Class A Motorhomes are constructed on medium-duty truck chassis that are supplied by companies such as Ford (F), Freightliner and The Shyft Group. Class C and B are built on Ford, General Motors (GM) and Mercedes-Benz (MBG) small truck or van chassis. In either case, Thor designs and installs a living area on the supplied motorhome chassis. It’s a similar dynamic in Europe with Thor assembling motorhomes from chassis made by Stellantis (STLA), Mercedes-Benz, Ford and trucking company Iveco. The nomenclature is slightly different in Europe as RV trailers are generally referred to as caravans and motorhomes are called motorcaravans. Thor notes that in Europe “the focus is on light and small caravans that can even be towed by small passenger cars.”

Thor entered the European market through the acquisition of Erwin Hymer Group (“EHG”) in 2019. Note that Thor has done a lot of growth through acquisitions and EHG was one of many. The company bought Jayco in 2016, which was a big boost to the towables segment, and then acquired Tiffin in 2020 which added to the Motorhome segment. The following graphic highlights improved net profit before taxes at the acquired companies. Each saw a gain in margins, except EHG. I’ll touch on M&A again in the capital allocation segment.

Thor generates most of its revenue through the North American Towables segment, which accounted for 53.1% of sales in fiscal 2022. Most of that is within the smaller travel trailers segment, rather than fifth wheels. North American motorhomes made up 24.4% of 2022 sales, which is the highest for Thor since 2018. 4.0% of the improvement in the past four years is driven by Class B for all those consumers in the #VanLife culture. Lastly, the European segment made up 17.7% of sales. The table shows the make-up of sales by percent since 2017.

Because motorhomes have expensive drivetrains that are built on large truck chassis, it’s no surprise they’re relatively expensive as compared to travel trailers. In addition to breaking out revenue by RV type, Thor also breaks out units sold by RV type. I strung together data from several 10-Ks and as you can see below, travel trailers made up 58.1% of the units sold compared to 33.3% of the revenue. Meanwhile, Motorhomes (all three types), made up 9.0% of units sold in 2022 and 24.4% of revenue. The table breaks out sales by unit (instead of dollar value above).

The margin profile has generally been slightly better for towables as compared motorhomes. Gross profit margins for North Amercian Towables were 17.5% and 16.4% for motorhomes. And towables have been about 3.0% higher than motorhome homes each year. Gross profit margins for the European segment has lagged North American overall at 14.2% in 2022, though that’s up from previous years.

Margins have similarly been higher for towables when stepping down to income before taxes, according to Thor 10-Ks that break out margins by segment. What is noticeable when looking at margins at Thor is how bad the European segment is. Profit margins were 3.0% in 2022 and graphic highlighting acquisitions above said EHG (European) was 4.0% when acquired. Not only does it lag other segments, but it’s also dropped over time. 2019 and 2020 figures were dragged down by integration costs. Even still, the lag is dramatic.

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Thor’s main competitors in North America is Forest Rivers (owned by Berkshire Hathaway) and Winnebago Industries (WGO). According to Thor, the RV market is intensely competitive and is characterized by low barriers to entry. The competition section of the 10-K said there was approximately 65 RV manufacturers in the U.S. and Canada in 2020, which increased to 70 in 2021 and 80 in 2022. It’s a quick rise in recent years that indicates new competition from upstarts.

According to the March 2023 10-Q, Thor had 40.9% market share of North American towables (trailers) and 48.3% market share of North American motorhomes, for overall market share of 41.7% according to retail units. Thor had market share of 47.9% in 2016, upon acquiring Jayco, and it’s steadily declined due to a drop in market share of towables which makes up most of the market. The pick-up in Motorhomes in 2021 (light blue line) was driven by the acquisition of Tiffin. I’ll add that EHG has the second highest market share in Europe at 18.0%, though considering it was acquired 2019 there’s not a long trend of data. Overall it’s a poor trend to see the money-maker towables decline in market share.

Thor intends to minimize its own inventory, so RVs are generally built to dealer order. Manufacturing is quickly ramped up and down in North America, though it tends to be more sticky in Europe. This is largely due to stricter labor laws in Europe. When it comes to raw inputs, such as steel, lumber and fiberglass, Thor is supplied by numerous providers. There has been issues with chassis suppliers in recent years, specifically constraints for key components such as semiconductors with demand outpacing production and it’s negatively harmed motorhome manufacturing. Non-chassis components have also been constrained in recent years. Parts suppliers for RVs seems particularly concentrated. LCI Industries (LCII) is the main parts maker and they own 55% of the RV market-share.

The sales channel works in a way that Thor sells to dealers, who then sell to customers. The dealers are generally independent, non-franchise entities for which ~2,400 carried Thor products in 2022. Another 1,100 European dealers carry Thor products. One dealer customer, FreedomRoads, more commonly known as Camping World (CWH) is particularly large. FreedomRoads accounted for 20% of sales in 2018, 18.5% in 2019, 15% in 2020 and 13% in each 2021 and 2022. Thor notes that it generally doesn’t finance dealer purchases, which are instead financed through unrelated banks. Apparently, it’s common for RV manufacturers to put in place repurchase agreements with the banking lending to dealers. So, what's a repurchase agreement? Basically, if a dealer defaults on their loan within 18 months, Thor steps in and buys back the unsold RVs from the lender. The amount they pay is often less than the dealer's original cost. This spreads the risk of loss over many dealers and is further reduced by the resale value of the units they'd repurchase. Thor believes any future losses under these agreements won't have a significant impact on their bottom line.

As of July 31, 2022, Thor's total commitments under repurchase obligations were $4.3B, up from $1.8B the previous year. Good news though, losses from repurchases haven't been significant in recent years. When selecting dealers, Thor looks for financial stability, creditworthiness, reputation, experience, and strong customer service.

Now that the flow of sales is understood, analyzing backlog and dealer inventories is critical. As of January 31, 2023, Thor had a backlog of $6.1B in RV orders, half of which is from North American dealerships. Backlog consists of unfilled dealer orders. The total backlog is down from $17.7B at the close of January in 2022. In January 2019 and January 2020, North American backlog was about $1.5B so the 2023 backlog is still elevated at ~$3.0B. According to the 2021 10-K, backlog increased by about $767M because of their acquisition of Tiffin. Taken together, it’s normal to see a North American backlog of $2.0B and $1.2B for the European segment.

The elevated backlog, and an extreme backlog in 2021 and 2022, are due to the increased demand for RVs during and after the onset of COVID-19 in addition to constrained demand for much of that time period. Thor wrote in their 2021 10-K:

“We believe this increase is attributable to a number of causes, including the perceived safety of RV travel during the COVID-19 pandemic, a strong desire to socially distance, the reduction in commercial air travel and cruises, an underlying desire by many to get back to nature and relax with family or friends, an increase in various marketing campaigns to promote sales, and to a lesser extent, supply chain issues which delayed certain shipments beyond July 31, 2021 and which prevented us from further increasing production rates, and the lower levels of independent North American and European RV dealer inventory levels, all of which have led to increased dealer orders and backlog.”

Essentially interest in RVs spiked, a logical travel option during COVID-19 restrictions. Now the backlog and dealer inventories are normalizing. The stock has struggled through the process of getting back to normal, and that’s largely why Thor is particularly interesting right now. On the topic of dealer inventories, Thor provided the following chart in March 2023 looking at dealer inventories of Thor products. To take the data slightly further back, the inventory count in January 2018 was 155,650 units making for an average pre-covid inventory count of ~136K. Consider that Tiffin was acquired in December 2020 so the normal inventory count should be closer to 140K units. The willingness of dealers to hold 140K units will depend on the strength in sales at the time. I’ll dive deeper into the subject later in the outlook section, but I’ll note for now that the market has soured quite a bit this year and the current dealer inventory is likely fully stocked given the environment.

Capital Allocation: The source of growth at Thor has largely been through acquisitions. Over the last 10 years, Thor has generated cash from operations of $4.3B. The company spent 23.3% on capital expenditure to grow and maintain the existing business. Stockholder returns have been modest with 6.8% of free cash flow (“FCF”) going to buybacks and 21.4% going to dividends. Meanwhile, Thor spent 108.4% of its cumulative FCF on acquisitions dating back to 2013. As mentioned, the large purchases were Jayco in 2016 and EHG in 2019. Jayco was funded by cash on hand and debt. The EHG merger was larger and involved Thor issuing stock to EHG, and the share count saw a 3.6% increase that year.

For the capital allocation review, I used Winnebago (WGO) as the comparison company. The use of capital is quite similar for Winnebago who spent 20.4% of its cash from operations on capital expenditures and 96.1% of its FCF on acquisitions. Winnebago has leaned on dilution/issuing stock for mergers, especially the purchase of Grand Design which caused a large jump in the outstanding count in 2017. The second big jump in outstanding was in 2020 when it bought motorhome maker Newmar. Other notable acquisitions for Winnebago are marine companies Chris-Craft in 2018 and Barletta Pontoon Boats in 2021. Winnebago now generates 13% of its revenue from marine. Another material difference has been shareholder returns with WGO spending 31.3% of its FCF on buybacks and only 9.4% of its FCF on dividends.

Both companies have been opportunistic with stock buybacks, and Thor is rarely in the market for its shares. As you can see by the year-by-year table above each company ramped up buybacks in 2022 while the RV market softened. The difference in buybacks to dividends may have contributed to the outperformance of Winnebago. However, more of the difference is chalked up to the selection and integration of mergers. Recall the graphic shown earlier that visualized margin improvements at Thor acquisitions. The only acquisition that saw decreased efficiency was Thor’s largest acquisition EHG. That’s generally when Thor stock started underperforming against Winnebago.

To back up the above stockholder performance chart, I’ll note that FCF at Thor increased at a compound annual growth rate (“CAGR”) of 22.5% while Winnebago achieved a FCF CAGR of 55.7%. The increase in revenue has been more similar, so there’s clearly been a gain in operational efficiency.

Management and Incentives: Robert Martin has been CEO since August 2013 upon promotion from his last role of president and COO. He joined Thor in 2001 from another RV company, Coachman, and worked his way up the ladder through executive positions associated with Keystone. He began leading the Keystone in 2010, which was the largest subsidiary for Thor.

COO Todd Woelfer joined the company in 2012 as general counsel until promotion to his current role in 2021. He too worked at Coachman from 2007 - 2010. The two-year gap between Coachman and Thor was spent as a managing partner at a law firm focusing on corporate clients. It’s uncommon for general counsels to shift over to operations, such as Woelfer. Lastly, Colleen Zuhl was also promoted from within to CFO in 2013. Zuhl joined the company in 2011, initially serving as director of finance then corporate controller. Prior to Thor, Zuhl similarly worked at Coachman from 2006 to 2011, so there was overlap with Woelfer, but not Martin.

As with most companies, base salary is a small fraction of total compensation for executives. Thor points out that CEO Martin, at $750K in 2022 salary, was 20% lower than the next lowest in the peer group. The general counsel was also below the whole peer group. Instead Thor favors variable compensation. That’s generally two buckets - annual compensation paid in cash (bonuses) and long-term, stock-based compensation. Compared to the norm, the portion of total compensation paid out in the form of bonuses is relatively high. It’s common for companies to pay most of the compensation in the form of long-term incentive pay, but that was actually lower than short-term pay (bonus).

The following graphic by Thor shows the distributions of pay by base salary, short term incentive pay (bonus) and long term incentive pay (equity). As a comparison, the CEO’s pay at Winnebago (WGO) was 15% salary, 19% bonus and 66% equity. Other executives had 28% total compensation in salary, 26% in bonus and 46% in equity. The big difference is more bonus pay at Thor and less salary. However, I’d prefer to see the CEO of Thor have a large percentage of his pay in equity.

Let’s dig into the performance drivers to compensation at Thor. Variable short term incentive pay is paid in cash, on a quarterly basis. It is essentially a profit sharing plan as Thor pays executives a percent of the adjusted net before tax profit (“NBT”). For instance, CEO Martin was paid 0.511% of the NBT and Woelfer was paid 0.178% while Zuhl had a percentage of 0.153%. If you like to nerd out about legal language in filings, I found the changes to the section in the proxy covering this quite amusing as each year the wording got softer as they began to rely on adjusted earnings.

• In 2020, Thor said “We generally rely on true GAAP numbers for purposes of calculating our NBT and do not otherwise manipulate earnings.”

• In 2021, they remove phrase manipulate earnings and instead said “We generally rely on true GAAP numbers for purposes of calculating our NBT and do not otherwise adjust earnings for purposes of these calculations.”

• Then in 2022 Thor took out true GAAP and that they do not adjust earnings, while adding which adjustments they make. “We generally rely on GAAP numbers for purposes of calculating our NBT which includes standard adjustments, to exclude gains/losses as a result of LIFO, non-controlling interests, impairments, and certain foreign currency exchange gains/losses.”

Long term incentive pay is split between restricted stock units (“RSUs”) and performance share units (“PSUs”). The RSUs, like short term pay, uses NBT as a metric to determine the value of RSUs for the year. However, vesting is then in equal installments without performance. It’s an unusual program to attach the value of RSUs to annual profit. PSUs instead vest based on performance over a three year cycle. The performance metrics of PSUs are split evenly between free cash flow (“FCF”) and return on invested capital ("ROIC") goals versus forecasted performance.

I’m a fan of attaching FCF to PSUs and while I appreciate capital allocation and the association to ROIC, it’s a metric that’s calculated inconsistently. Also note that none of the performance pay is tied specifically to revenue growth. Management instead is incentivized to drive profit and cash flow.

Outlook: The RV industry has grown well when focused on units alone. In 1990, wholesale units were 173.1K, which has grown to 493.3K in 2022 for a CAGR of 3.3% (US population grew at about 1.0% per year in that period). It’s been volatile at times with a big downturn in 2009 when units were sliced in half compared to two years earlier. As noted, volume soared in 2021 when the industry reached a high watermark of 600.2K units. The chart below splits up industry-wide towables and motorhome units. It’s a nice overall trend for the industry because companies could simply increase prices at the inflation rate and generate +5% growth in revenue when accounting for the rise in units sold. The expectation by the RV Industry Association (“RVIA”) is ~334K units in 2023 so volume is nearly getting sliced in half again against 2021.

Long-term, there are some tailwinds in the RV industry driven by good demographic trends with a heightened number of retirees and increasing interest from younger generations such as millennials. Retirees have generally been beneficial to RV purchasing and we’re two-thirds the way of baby boomers reaching retirement age. Boomers are born between 1946 and 1964. For the tail end of that, a person born in 1964 is 59 years old right now, or six years away from 65 (a common retirement age). Put another way, there’s still another six years of elevated numbers of Americans retiring each year. An economist at the Federal Reserve of St. Louis put this chart together four years ago forecasting the number of Americans turning 65 each year. I’m sure it’s changed a bit post-covid but the point is there continues to be elevated amounts of Americans retiring and potentially enjoying life on the road as an RVer.

The second positive demographic tailwind is an uptick in the interest by younger generations such as millennials. Despite the uptick in retirees in recent years, baby boomers make up about 20% of RV ownership. The bulk of ownership is now from Gen-X and millennials. As workers enjoy a work-from-anywhere lifestyle, it’s made for an increased ability and interest to spend more time RVing. RV industry companies have done plenty of surveying to tout the interest by Gen-Z and millennials, such as RVIA. The surveying seems quite biased and targets RV goers so I’m not going to rely on it. According to RVIA, “of the current millennial and Gen Z owners, 84% have said they want to purchase a new unit in the next five years”. I’m more interested in surveys that could tell how many non-RVers will become RVers, rather than current RVers planning to purchase in the next five years. I will add some commentary from Thor management to give insight into the market outlook. Matt Zimmerman, head of North American RV Group, said in the June 2022 investor day:

"Many of you in this room probably are well aware that baby boomers one time fueled our industry for many, many years as the #1 demographic in the industry. Today, they're the third largest group and only represent 22% of the overall RV space. But don't get me wrong, we love our boomers. And we will certainly continue to build products and serve them up to them that they desire.

But Gen Xers and millennials today represent nearly 70% of the RV space. And if we're not building products that are attractive to these young enthusiasts, then we're missing out on incredible opportunities.

For the first time in my career, RV-ing isn't just something what the grandparents did. It's the cool thing now, right? This is how these young enthusiasts want to get outdoors. They want to connect. They want to use an RV.”

There’s also a potential increase of consumption stemming from the ease of renting through peer-to-peer RV sites. Last year I used Outdoorsy, a P2P site, to rent and tow an RV. I enjoyed it enough that I’m taking my second trip with my family this summer. I’m a suburban living millennial and can’t say that I’d purchase an RV because I wouldn’t use it enough. But I am interested in renting an RV for a trip once a year or so. Therefore, a consumer with my buying behavior could contribute to RV demand by renting and I’m in a demographic where RVing wasn’t so popular five years ago.

While the medium to longer-term tailwinds are good, the short-term headwinds are unfortunately stronger. When Thor reported earnings for fiscal second 2023 results (Q2’23) on March 7, the company slashed its sales expectations for 2023 to $11.0B (midpoint) from $12.0B. The new guidance represents a -32.6% drop in revenue compared to the record sales in fiscal 2022. Softening demand is directly tied to the rise in interest rates and inflation. Buyers generally finance an RV and the willingness to buy an RV at relatively high interest rates has depressed demand. In addition, inflation has hurt consumers’ ability to afford RVs. They’re highly discretionary objects so when you’ve got to cutback, the purchase of an RV isn’t in the cards. Management said the in Q&A of its March earnings release:

“Entering calendar 2023, we experienced an encouraging early spring retail show season across the country with high attendance figures and solid retail activity, reinforcing the underlying strong interest for the RV lifestyle. However, activity on dealer lots has not matched the strong show season and sales conversions have been challenged. While we had anticipated softening retail activity in our fiscal second quarter, it was more pronounced in the back half of the quarter, suggesting that retail consumers are succumbing to the macroeconomic pressures most prominently triggered by the Fed's rate policy in the face of sustained inflation.”

“While near-term demand will continue to be influenced by macroeconomic conditions, we believe that the recent greater-than-expected softening in demand will be temporary, and in the longer term, we remain strongly optimistic about both the industry's and THOR's future growth…This longer-term optimism is supported by data that indicates interest in the RV lifestyle continues to exceed pre-pandemic levels, RV utilization remains high, consumer satisfaction among RV owners is very strong, and repeat buyer intentions reaffirm the “stickiness” of the RV lifestyle. The strength of the consumers' interest in the lifestyle has been demonstrated by strong show attendance across North America despite the macro pressure on consumers. Given these facts, we believe that retail demand should rebound once current macroeconomic risks subside. As we think about our stock, the short-term challenges created by the macro environment will create turbulence in reaching fair value, but for holders with a longer time horizon, the temporary depression of our performance creates opportunity. Nothing about the short-term turbulence casts any legitimate doubt on our long-term optimism.”

Another comment that caught my attention in the March update was on dealer inventories. As I mentioned earlier in this write-up, it appeared the backlog was quite robust. Management said:

“As of January 31, 2023, we believe North American dealer inventory levels for most of our towable products are slightly higher than dealers' desired levels given current retail sales levels, inflation, rising interest rates and other associated carrying costs while dealer inventory levels for our motorized product lines are generally more closely aligned to dealers' desired stocking levels as of the end of January 2023.”

My point of view is that until the cost of borrowing subsides, and the inflation rates come down further, Thor will struggle. As of May 2023, the fed funds rate is at 5% and interest rates on buying RVs is often above 7.0% (my local credit union is above that). It could take well into 2024 for interests to come down enough to spark a rebound in buying of RVs. It’s also notable that Thor management has repeated that RV show attendance has been high. Perhaps there will be pent-up demand for RV buying after a drop in interest rates.

Valuation: For my DCF model, I’m forecasting revenue of $11.0B for fiscal 2023, which matches the current management forecast and is lower than the analyst consensus estimate of $11.18B. Part of this is because I’m in the higher for longer camp (for interest rates) meaning the headwinds of costs to consumers is too great right. Regardless, $11.0B will be tough to achieve after fiscal Q2’23 sales were -39.4% YoY. By my calculations the second half of the year will have to be no worse than -22% YoY. I’m taking the ~$200M miss (against the sell side target) and pushing that and some into 2024. Then I’m forecasting Thor returns to elevated growth. Sales will still remain well below the fiscal 2022 mark.

The average EBITDA margin is 7.7% for the last 20 years (including 2008/2009 financial crisis lows) and 8.7% over the last 10 years. The DCF model includes poor margins of 7.0% in 2023, then settles at 7.7% for the last three of the model to match the historic average. I know Thor is hoping to improve margins, and outlined goals for increasing the European segment. Supply chains and labor dynamics seem tougher in the EU so it’s not clear they can achieve the goal of enhancing margins by 2.0% for Europe.

Thor forecasted capital expenditure spend of $200-$220M for 2023 (2.0% of revenue). The average over the last five years 1.4%. The DCF generally has CapEx equal to 1.5% of revenue. Other line items that flow to the free cash flow calculation similarly match the average of the last five years on percentage terms.

Now that I’ve laid out the cash flow forecast, the next two important inputs are the exit multiple and discount rate. Thor has an average trailing EV/EBITDA of 7.2 over the last five years and 8.5 over the last 10-years. I’m opting for 7.5 in the DCF while keeping in mind Thor would have topline growth of 6.0% at the time. Given the high cyclical nature of Thor, shares have experienced a high beta of 1.28 for the last two years and 1.74 for the last five years. I’m picking 1.5 to calculate the discount rate. Current debt to equity is 47.6%. Therefore the current discount rate calculates out to 10.7%, though I’ll round up and go with 11.0%. The following summarizes the DCF model and values Thor at $116.18 per share for 45% upside.

Modeling Thor is unpredictable given the potential demographic changes and potential M&A. I’m not sold that millennials will accelerate sales in the future. If it does happen, you could see further upside. As noted several times, Thor has grown significantly through M&A. However, this model assumes no M&A. Theoretically the fair value doesn’t have to change much as you take current cash flows to increase future growth and cash flow. Whether an acquisition by Thor pans versus the cost/valuation of shares is uncertain. Some work, some don’t. In order for Thor to increase its value through M&A, they have to buy below fair value and/or achieve synergies that are less than integration costs. In addition, Thor will be materially impacted by future interest rates, which are also highly unpredictable right now.

For good measure I’ll note that buying Thor based on a relative valuation approach (against Winnebago, LCI Industries and Polaris) calculates a slightly lower fair value price than the DCF. When valuing Thor (or Winnebago) on a trailing basis, such as EV/EBITDA, the price appears cheap with the industry in a trough. These two stocks have traded similarly over the last 10-years as can be seen on the chart below showing last twelve months EV/EBITDA multiple.

The current valuation according to the forward EBITDA (instead of last year’s EBITDA) is quite close to the historical average which indicates Thor is close to fair value. Note that Thor and Winnebago have been closely tied through both metrics. And Winnebago is slightly cheaper, especially when looking at EV/EBITDA for the next twelve months (NTM). Boat maker Brunswick (BC) trades at 5.9X right now too so perhaps Winnebago is dragged lower by marine.. I’m not a fan of simply attaching on valuation metric on a forward or trailing basis when the sales pattern is so inconsistent. You tend to get more insight through a DCF model which allows for fluctuations in sales.

Conclusion: There’s solid potential upside in Thor for those who can stomach the current volatility in sales and wait for the longer-term. By factoring the forward EV/EBITDA and DCF model, I’ll give Thor a $110 price target indicating about 35% upside. It’s not enough upside for the risk, in my opinion. Sales will continue to struggle through the remainder of fiscal 2023 (July 31). After learning more about Winnebago through this research, those shares also look appealing. Winnebago has operationally outperformed Thor, shares have been stronger in recent years and the valuation multiple is a touch cheaper. However, Thor is a pure play on the RV industry while Winnebago has some boating exposure to keep in mind.

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Disclaimer: This is not advice to buy, sell or hold any stock referenced. Do your own due diligence. I have no position in any stock mentioned in this report. Like any financial analyst, doesn’t mean I’m not biased.

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Overview: WEX is a commerce platform that is “focused on simplifying the business of running a business.” Simplicity comes from helping customers automate manual processes and reconciliations, offering solutions to tackle healthcare benefits and administrative challenges. By leveraging its software capabilities, WEX offers three business segments: Fleet Solutions, Health and Employee Benefit Solutions and Travel and Corporate Solutions. There’s a subsidiary, WEX Bank, that supports the business and manages HSA assets.

WEX is a unique payments and software company because it’s highly cyclical and seasonal. The Fleet Solutions business has historically been tied to fuel prices, Travel and Corporate fluctuates with the seasonal nature of travel (more in the summer). Meanwhile, Healthcare is increasingly being tied to interest rate yield due to the growth of the HSA business.

The largest segment by revenue is Fleet Solutions which made up 61.4% of 2022 revenue. Fleet solutions provides payment services and information management services specifically for entities managing large fleets of vehicles. This network captures rich data and enables custom controls, helping fleet managers control spending, reduce fraud, and optimize operations. WEX captures various information at the point-of-sale and offers standard and personalized reports, alerts for unusual transactions, and real-time analytics. Fleet Solutions generally makes money through payment processing. Depending on the global region, the mechanics can differ. Generally, Fleet Solutions makes a percentage of the aggregate dollar amount of the customer’s purchase, a per transaction fee, or a combination of the two. Note that Wex has partnerships with nine of 10 top U.S. fuel retailers. The European segment makes money based on the difference between a negotiated price of fuel from suppliers and a price charged to customers.

When I first read about the Fleet Solutions segment, my mind quickly wondered if WEX can transition to an electric vehicle (“EV”) world. Judging by the change in the 2023 10-K, it’s at the top of the mind of management. The following was added to the Fleet Solutions section:

“Building upon our historical ICE related fleet solutions, we are working on solutions we believe will ease the integration of EVs into mixed fleets. We believe we are uniquely positioned to help our customers transition to an expected mixed-fleet future…We are building on our deep experience in fleet and mobility in an attempt to develop and provide solutions to address specific customer needs, including charging, EV transition planning, and tools to successfully manage a mix of vehicle types ranging from connectivity to advanced route planning and carbon emissions reporting.”

The Fleet Solutions offerings are sold directly and indirectly to businesses and government agencies with fleets of all sizes. The product is also sold to long-haul fleets. Fleet Solutions competes against specialized companies such as Fleetcor (FLT), U.S. Bank Voyager (USB), Radius Payment Solutions, DKV and Edenred. In addition, there’s some competition from large financial institutions that provide payment services for fleets. However, those offerings don’t include the detailed reporting and fraud prevention that WEX can offer.

Before I discuss the financials of Fleet Solutions, I’d like to point out that WEX has great transparency. All business lines have revenue and costs detailed by subsegments. This makes it easy to understand the drivers of sales each year. In addition, WEX breaks out revenue by “topic 606 revenue” and “non-topic 606 revenue”. For those who don’t know, topic 606 is an accounting principle that outlines how a company should recognize contract revenue, which in some cases can help understand recurring revenue.

I extracted the last six years of revenue and key performance indicators (“KPIs”) from 10-Ks (finance fee revenue is broken down even further in the filing). Gallons processed isn’t provided by WEX, but I simply calculated it as payment processing dollar of fuel divided by the average U.S. fuel price of the year. This is important to know because it shows how sensitive this business is to fuel prices. Gallons processed was up a modest ~3% and number of transactions was up about 9%. Total revenue was up 30% YoY and the payment processing revenue was up 40%. WEX in the 10-K says $195M of the increase was from increases in fuel prices. So in reality total revenue would’ve only grown by about 12% YoY had fuel prices stayed even with 2021. Recall WEX makes money as a percentage of the aggregate dollar value processed and/or per transaction fee. While growth has been impressive in the past two years, it was negative in 2020. Reported compounded annual growth rate (“CAGR”) for five years through 2022 was 10.5%.

The margin profile of Fleet Solutions also has also been volatile. 2020, 2021 and 2022 operating margins were roughly 22%, 40% and 30%, respectively. Most of the drop in margin for 2022 was driven by an increase in provision for credit losses, which includes credit and fraud losses. WEX is essentially fronting the money for customers to buy fuel and services, then getting paid a month later. Naturally during times of stress, customers go bankrupt and don’t pay WEX back. Here’s what WEX said about this cost in their 2023 10-K.

“Slower payments from small customers in our over-the-road business, which we believe is due to higher fuel prices and declining spot shipping rates, have been a significant contributor to the increase in credit-related losses. We additionally believe that higher fuel prices have contributed to the increase in application and transactional fraud-related losses. Efforts to refine the fraud prevention and monitoring tools we use has slowed the higher rate of fraudulent activity experienced during the second and third quarters of 2022, when fraud losses contributed approximately 11 basis points to the overall credit loss provision, to approximately 6 basis points in the fourth quarter of 2022. In addition, we are in ongoing conversations with our merchant partners in our over-the-road business to address the sources of elevated transactional fraud we experienced during 2022, and in some cases to shift the financial responsibility.”

Clearly Fleet Solutions has been tied to the volatile price of fuel. Going forward, the business may stabilize more when fleets rely on electricity, which has historically been notably less volatile.

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The health and employee benefit solutions segment is the second largest of three making up 21.4% of 2022 sales. WEX's Health and Employee Benefit Solutions segment offers a comprehensive suite of software and services to simplify the administration and management of employee benefit plans. Solutions include consumer-directed benefits, non-bank custodial services, COBRA administration, enrollment and benefits administration, and administrative services. WEX distributes its software through partners that include third-party administrators, payroll providers or health plan companies. The software can be white-labeled so you may not know you’re even using WEX, or WEX-branded. WEX currently serves more than half of the Fortune 1000 companies in the US.

The Health and Employee Benefit Solutions segment makes money from three sources:

1. Per participant per month fees: WEX charges fees for their software and administrative services based on the number of participants using their platform. This includes services such as managing and administering employee benefits, providing customer support, and offering data analytics. Note there was 18.7M SaaS accounts as of December 31, 2022. The average number of accounts was up 11% YoY.

2. Interchange on debit cards: WEX earns interchange fees when plan participants and their dependents use debit cards to pay for eligible expenses from their benefit plans, such as Health Savings Accounts (HSAs), Flexible Spending Accounts (FSAs), and other account-based benefit plans.

3. Interest on deposits and fees related to cash balances in Health Savings Accounts: WEX earns interest and fees on the cash balances held in Health Savings Accounts under their custody. This includes accounts managed by WEX Bank and third-party depository partners. At the close of 2022, WEX was a custodian to $4.5B in HSA assets, of which $3.45B was in cash (up 23% YoY) and $1.1B was held by third-party brokerage firms. $1.4B was held by third-party depository partners. The remaining $2.1B was deposited with and managed by WEX Bank. I’m going to circle back on the importance of those numbers.

Competition has three arenas. Benefit solutions competition with Alegeus Technologies and DataPath. Banking platforms from Fidelity National Information Service (FIS), Fiserv (FISV) and Jack Henry (JKHY). Lastly, benefit enrollment from HealthEquity (HQY), Alight Technologies (ALIT), Businesssolver and PayFlex.

Revenue from the Health and Employee Benefit solutions business is the most steady of the three. The following breaks down revenues, including the KPIs provided by WEX. Total revenue for the segment has generally been around 18% YoY, save for 2019 when it was 48% due to an acquisition. 2022 revenue was up $90.3M, or 22% YoY. Half of the growth in 2022 was driven by the continued rise in payment processing and account servicing fees that are tied to the increase in the number of SaaS accounts using WEX’s services. The other half came from Other Revenue which is the earnings on cash held by WEX Bank for HSA accounts, which is effectively WEX taking HSA deposits it manages and holds and investing in treasury bills for risk-free cash. Average yield in Q4’22 was 3.4% on the HSA assets.

The rise in revenue from HSA accounts at WEX has been very interesting. In April 2021, WEX paid $200M plus $50M in deferred payments for contractual rights to HealthcareBank to serve as the HSA custodian to over $3B in assets. WEX then transferred nearly $1.0B of custodial cash it previously held with third-party depository partners to WEX Bank to be managed and invested internally (by WEX Bank). These moves have made WEX Bank the sixth-largest HSA custodian. Given WEX’s role in servicing healthcare customers through the software product, WEX has a great path to add more HSA customers. Note the revenue stream is tied to interest rate movements so the yield could drop in the coming years.

The third segment is the Travel and Corporate Solutions segment which made up 17.1% of 2022 revenue. This business is dedicated to complex payment processing and tracking for global B2B payments that offers accounts payable (“AP”) automation and spend management solutions. WEX targets customers such as online travel agencies, tour operators, airlines, fintech firms, and companies focusing on spend management, accounts payable automation, insurance payments, and media payments. According to the website, customers include corporations such as Expedia (EXPE) and Costco Travel (COST). The software turns highly manual and costly AP functions to very automated processes.

Their virtual card solution is at the core of the segment's product offerings, with virtual cards being used for transactions where no physical card is presented. The unique virtual card numbers (“VCNs”) offer customized spend limits, expiration dates, and purchase controls to limit fraud and unauthorized spending. This virtual card solution, featuring global currency capabilities and a global compliance and funding mechanism, is particularly appealing due to its reconciliation, fraud protection, chargeback protection, and rebate generation capabilities.

WEX differentiates itself from competitors by offering additional solution features, such as customized data fields that can tie together invoice numbers, booking numbers, or purchase orders to help automate reporting and reconciliation. The various virtual card products optimize interchange yield, execute bank transfers and check issuance. For AP automation and spend management, they provide customizable integrations with different ERPs, enhanced AP data analysis, supplier enablement teams, and user interfaces.

The segment's revenue mainly comes from net interchange revenue (fees earned during a credit card/debit card transaction), with a high variable margin contribution due to the largely fixed or semi-fixed cost nature of the solution. Licensing fees are charged to leading partner financial institutions that white-label WEX's AP automation and spend management solution. The financial institutions similarly pay a technology fee as a percent of the spending that the software allows them to process.

The Travel and Corporate Solutions segment competes against financial institutions such as J.P. Morgan (JPM), Barclays (BCS), Capital One (COF), and Citi (C) that have payment capabilities. The specialized financial technology companies that have processing capabilities called out in the 10-K include I2C, Global Payments (GPN), Marqeta (MQ), who partner with several banks to provide payment services.

Like I’ve done with the other two segments, the following breaks out revenue by topic over the last six years for the Travel and Corporate Solutions business. Annual revenue growth has generally been solid over this period, save for 2022 due to the COVID-19 pandemic when revenue dropped -24% from the prior years. Even including that, the five-year CAGR for revenue from 2017 to 2022 is 12.4%. 2022 revenue increased 24% YoY and nearly all revenue for this segment comes from payment processing. The increase was primarily driven by the continued rebound in travel in 2022. Note that purchase volume processed essentially doubled in 2022, though the net interchange rate (percentage of transactions earned that is payment processing revenue) dropped to 0.53%.

Strategy: The overall growth strategy is focused on innovating in the payments and business technology industry through the following initiatives:

• Global Commerce Platform: WEX emphasizes the importance of a reliable, scalable, and global platform to deliver customer solutions. They aim to anticipate customer needs and continuously improve technology.

• Personalized Solutions, Seamlessly Embedded: WEX focuses on delivering customized solutions tailored to address customers' specific pain points.

• Insights that Power Success: WEX leverages its extensive data and specialized expertise to provide valuable insights for customers.

WEX says its choice to grow the business is expected to deliver across five drivers:

1. Win New Customers: WEX aims to drive organic growth by nurturing customer relationships, ensuring they are a trusted strategic partner, and using their support and service capabilities to win new customers.

2. Grow Share of Wallet: WEX plans to expand its relevance and value to customers by increasing the services they provide. They have a unique combination of solutions that can serve customers in multiple areas, and they see an opportunity to penetrate their customer base more deeply across all solutions.

3. Expand & Diversify Offerings: WEX continuously seeks to identify, experiment, and launch products in new solution spaces to stay relevant and at the forefront of serving customers' needs as business models evolve.

4. Deepen Global Presence: As a global business, WEX aims to leverage its platform capabilities across geographies to continue growing its international presence.

5. Strategic M&A: In addition to organic growth, WEX plans to achieve growth through strategic acquisitions that bring further scale and diversification to their offerings.

Capital Allocation: Analyzing capital allocation programs is a good way to figure out how companies grow. In the table below, I show the capital allocation for each WEX and Fleetcor (FLT) over the past 10 years. WEX has spent 24% of its cash flow from operations back into the business via capital expenditures, which compares to just 8% for FLT. WEX has also been a lot more aggressive in M&A with 166% of its cumulative free cash flow spent on acquisitions, after netting out divestitures. FLT has spent 79% of its FCF on M&A. Neither company paid a dividend and instead opted for buybacks. WEX has been more conservative on this front with repurchases for the 10-year period equal to 18% of its FCF, far less than FLT who has done 74%. In return, WEX’s shares outstanding has increased a modest 11.8% while FLT’s shares outstanding has decreased -10.5%.

Note that WEX shifted capital allocation practice in 2022 by dropping M&A spend in lieu of buybacks. Just 20% of the FCF was spent on M&A, according to the cash flow statement, while 53% was spent on buybacks. 2022 represented the first time WEX bought back using its buyback program since 2015. Other buybacks since then were negligible and were done to satisfy tax withholdings of stock awards (that activity still gets tucked into cash flow statements that were used to build the table).

Despite WEX investing more heavily into CapEx and M&A, and less in stock repurchases, underlying financials have underperformed. The Revenue CAGR from 2013 to 2022 is 14.1% for WEX and 16.1% for FLT. Operating profit has also lagged with WEX at a CAGR of 9.5% while FLT achieved 14.5% CAGR over the 10-year period. Clearly this has been reflected in the stock that’s seen WEX shares increase at an annual rate of 9.2% and FLT at a rate of 14.5% per year. If you shorten the period by one year to use the start date of CEO Melissa Smith the stocks essentially performed the same, and revenue CAGR evened out, so 2013 was quite a year for FLT.

Management and Incentives: WEX has been led by Melissa Smith who has been CEO since 2014. Smith began her career as an auditor for Ernst & Young then joined WEX in 1997. Smith was promoted to CFO in 2001 and oversaw finance during the 2005 IPO. After that, she shifted to President of The Americas in 2011 until taking the top spot in 2014.

There’s been three CFO since Smith, excluding an interim CFO. The current CFO is Jagtar Narula who joined the company in May 2022 from 3D Systems (DDD) where he also served as CFO. As of this writing, the last proxy filed by WEX was in April 2022 and it listed Scott Phillips as the third highest-paid executive (behind Narula) when he was head of global fleet. Phillips left in January 2022 as part of a reorganization that saw President of Health and Benefits Robert Deshaies step up as Chief Operating Officer, Americas, in a position that oversees all three business segments and global marketing. Deshaies joined in 2014 when WEX acquired healthcare software and payment processing company Evolution1 for $533M. I’ll note that at the time of the reorganization, the head of travel Anthony Hynes moved to an executive advisor role. It was interesting that instead of taking the executive who oversaw the largest unit (Phillips/Global Fleet), they took the executive of the best-performing unit (Deshaies/Healthcare) and bumped him to third on the management hierarchy.

Again, I’m using the proxy filed in April that covers compensation through 2021 to gain insight into how management was incentivized. Just like business segments at WEX, there’s a lot of nuance to compensation at WEX and drivers of pay that are notable. The following shows the pay breakdown of CEO Smith in 2021. For non-CEO executives it’s typically skewed slightly more to salary while equally reducing pay from the long-term incentive plan (“LTIP”/SBC).

In reality, the breakdown between the different types of compensation doesn’t provide much insight. Instead, it’s the levers tied to stock-based compensation that matter, especially when SBC is +75% of an executive’s pay. For the short-term incentive plan (“STIP”), which is the annual cash bonus paid to executives, it’s weighted 60% to adjusted operating income and 40% to adjusted revenue. WEX notes “For NEOs leading a business unit, corporate goals are weighted 40% and business unit goals are weighted 60%.” Performance-based Restricted Stock (“PRSUs”) makes up 60% of total executive compensation at WEX and is calculated based on a two-year period that’s weighted 60% to adjusted net-income and 40% to adjusted revenue. However, there’s also a relative total shareholder return (“rTSR”) metric modifier tied to PRSUs. That means that payout of 60% of executive compensation is adjusted according to the relative stock performance. The remaining compensation is 15% RSUs and 25% stock options for CEO Smith and those numbers change to 20% RSUs and 20% stock options for other executives. Overall, WEX is essentially favoring margins over growth by weighing profit metrics more heavily than top-line growth.

Note that executive pay at WEX has changed in recent years, specifically with the addition of a relative total stockholder return modifier. What strikes me as odd is the fact that WEX retroactively amended 2019 awards to add the rTSR modifier. I generally dislike when companies retroactively adjust compensation targets. In this case, I don’t mind it because I like the use of rTSR. I only want to pay management to outperform other companies, not just beat internal fundamental targets. In addition to amending 2019 awards, the board also issued special equity awards in June 2020 that were 75% PSUs and 25% RSUs. The former was also tied to rTSR. The willingness to give special, off-cadence stock is generally an unusual move and WEX has shown in recent years they’re willing to move compensation goalposts around. Here’s what the company said in the 2020 8-K disclosing the move:

"The 2020 PSU award was designed to support our multi-year strategic plan and reward each of the officers for their contribution to the achievement of plan goals during the performance period…Three-year performance goals for these metrics were established and approved by the Committee on March 2, 2020. Since that time, the severity of the impact of COVID-19 on the global economy, and general economic uncertainty, increased significantly. In light of this, on June 23, 2020, the Committee changed the performance goal for the 2020 PSU award to total shareholder return (“TSR”)”.

At least WEX was fairly transparent with the special stock and change in incentives, even if it did make the cost of SBC balloon in 2022. SBC was about 2.5% of revenue pre-2020 and above 4% in 2020 and after.

Outlook: Upon reporting full-year 2022 revenue of $2.35B, WEX guided 2023 revenue to $2.45B (midpoint) for YoY growth of 4.2%. This compares to the analyst consensus estimate of $2.47B. Full-year 2024 revenue is then expected to grow 6.4% in 2024, according to the consensus estimate. WEX also offered adjusted income guidance in 2023 of $615.5M which would compare to the 2022 adjusted net income of $610.9M. WEX removes some regular non-ongoing costs but also stock-based compensation costs (which are not stopping at any point soon). The largest add-backs were acquisition-related intangible amortization, change in fair value of contingent consideration and impairment charges. The contingent consideration is because part of the cost to acquire HSA assets was tied to future interest rates, and WEX is essentially paying more (taking a financial hit) because interest rates increased.

It’s uncommon for management to include guidance assumptions, but the team at WEX did by noting a few important assumptions, such as the average fuel price being $3.83 dollar per gallon (compared to $4.46 in 2022). Management uses the NYMEX futures price to inform average fuel assumptions. The credit losses are expected to be 27 basis points in 2023, up from 26 basis points in 2022 and 8 bps in 2021. Guidance otherwise doesn’t assume further M&A or buybacks, according to the press release and supporting investor presentation. CFO Narula went beyond that context to give further supporting details in the February 9 earnings call.

• Assumes U.S. GDP grows at 0.5% in 2023. Fed Funds Rate adds another 25 - 50 basis points early in the year. Every 100 basis point would decrease adjusted net income by $10M so management has likely pulled back net income guidance $5M because of interest rates. This point is notable because if interest rates slide in the coming years, HSA revenue decreases, but net income would improve.

• Excluding a change in fuel prices, organic growth for fleet solutions would be 6%. However, given the drop in expected 2023 fuel prices, revenue was reduced by $95M.

• The travel segment is expected to grow 9% in 2023. “We see significant pent-up demand and continued strength in the demand for travel despite indications of a potentially slowing economy,” Narula said.

• Healthcare is expected to have the highest growth at 27.5% in 2023. “We have completed a successful open enrollment season and expect benefits from a significant increase in the custodial balances invested as well as higher interest rates.”

• Note that WEX has been executing on an ongoing cost-reduction plan that was instituted in late 2022. The goal is to save $100M in operational costs by 2024. “We expect adjusted operating income margins to trend up through the year as we get the benefit of these cost savings measures and reduced credit losses. All of this leads to EPS growth in the range of 0% to 4% due to the significant drop in fuel prices expected. [Excluding] out fuel price degradation and FX, we would expect adjusted EPS growth to be in the range of 11% to 15%.”

Since WEX delivered earnings on February 9, the futures price of gasoline has increased by about 5% while crude oil decrease by 3%. Recall the other two growth drivers are SaaS accounts and HSA assets, which are in part tied to interest rates, and spending on travel. The payoff from HSA assets is quite unpredictable given the macro outlook regarding near-term interest rates. On the flip side, WEX has floating rate debt so while interest rates can help the top-line growth of the Healthcare business but the overall bottom-line net income is negatively impacted. There’s generally a consensus that travel continues to pick up in 2023 and so far that’s played out.

Another topic I’d like to note before diving into valuation is the potential incremental revenue from EV and mixed fleets. According to WEX management, the TAM is upwards of $2.0B by 2030. CEO Smith said in the February earnings call:

“While the timing of this transition is uncertain, we believe it is becoming increasingly apparent that we will compete in the mix fleet world more than the next decade. The transition to EV introduces a new TAM that we believe will be valued at $1.5 billion to $2 billion in revenue and continues to grow reoccurring revenue for the company through subscription-based revenue streams. We've made great strides in EV in 2022, launching products allowing for the payment of charging at public locations in both the U.S. and Europe and are building functionality to allow for home charging reimbursement and energy management at depot locations, all designed to be integrated into the mix fleet offering with our industry-leading mobility products.”

In reality, revenue from EV fleets may not be significant over the next five years, so the biggest factor in analyzing WEX’s outlook is the price of fuel prices and the scale of the healthcare business. I’m not personally an energy specialist so I’ll defer to Reuters market analyst John Kemp survey results. Kemp annually surveys thousands of energy professionals to forecast oil prices for the following five years. The survey this year was conducted between January 10 and January 12 and had respondents from 1,066 professionals. The result was an average forecast for 2023 - 2027 of $87.00, $91.00, $91.00, $90.00 and $90.00. As a comparison, the 2022 average was about $99.00. Here’s the link to the report.

Valuation: I built a five-year discounted cash flow model to calculate the value of WEX shares. The base case DCF model starts with the average retail fuel prices of $4.00 in 2023 (down from $4.46 in 2022), and staying at around $4.10 - $4.15 through 2027. This is based on the noted survey results above. I’m also tucking in modest additional revenue into the “other revenue” section of fleet to account for a potential EV capture. Travel is fairly simple in that I’m expecting growth to taper from 10% to 6% over the forecast period. Healthcare is evidently off to a hot start for 2023 and management expects growth of about 27.5% for the year. I modeled higher SaaS and account servicing revenue tapering from 30% down to 12%. Separately, I’m projecting revenue growth from the HSA (other revenue of Health segment) to be about 8% during the period, which is more modest than the SaaS/account servicing side

EBITDA Margins are expected to improve over the next two years and edge higher then remain at 38%. This is partly based on the cost-cutting initiatives currently taking place. Note this compares to the median annual EBITDA margin of 34.2% since 2012.

Despite a complex revenue build, the calculation of cash flow will be more simple in this round. If you read my last deep dive on Qualys (QLYS), I backed out stock-based compensation and calculated the per-year dilution and also subtracted buybacks. WEX infrequently buys back stock and while I expect them to repurchase shares in 2023, it’s unclear what the appetite will be going forward given the opportunistic stance. Similarly, there’s a wide variance of potential dilution due to the nature of the performance-based stock. To be clear, the accounting costs of stock-based compensation is tucked into EBITDA.

Lastly, for the significant assumptions, the DCF uses a discount rate of 11%. The true weighted average cost of capital appears to be slightly lower, but I’m adding some risk due my perceived judgement of WEX. Beta is 1.1, equity risk premium is 5.9% for the US and the debt to equity in the industry is about 70% which would feed into a discount rate of 8%-9%.

WEX currently has a trailing EV/EBITDA ratio of 11X and it’s been 19X over the last five years. The current peer average is 15X and I’m exiting the DCF with 12X EV/EBITDA. The summary is shown below with the current estimated fair value of ~$288.00, which is 54% higher than the current stock price.

The above base case presents a potential outcome. WEX is a unique, cyclical payment processor and we’re in an uncertain macro environment that includes a potential recession. Therefore, I also modeled a bear and bull case. In the bear case, the average fuel price drops to $2.50 and then recovers. The Healthcare segment growth slows quicker. In the bear case, EBITDA margins would instead be around 30%, which is the low end of the margins over the last decade. All of this would instead calculate a fair value of about $214.00, or 14% higher than the current stock price. All things considered Mr. Market is assuming this path is more likely than the base given the current stock price. In the bull case inputs are skewed in the opposite direction with fuel prices moving as high as $5.00 five years out.

Even though it’s highly uncertain, I tend to think the bear case is slightly more likely than the bull case. So I’ve weighted the base 60%, bear 30% and bull 10%. The end result is a fair value of $270.00 (46% upside).n

Summary: WEX has plenty of upside at the current valuation though investors need to have an appetite for the cyclical nature of the businesses it processes payments and offers software services. Financials have been messy over the past five years and management has done a good job playing the cards they’ve been dealt. Even if the DCF doesn’t play out, investors are still buying shares near the low end of the relative valuation range, and slightly below most peers right now. Rarely have shares traded near 10X EV/EBITDA and the stock has been staying in the low teens over the last six months. Again, the market is assuming this business sours by pushing the valuation down to levels similar to Q1’16 and Q1’20. All things considered, I’m going to stamp this with my first ‘buy’ rating.

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Disclaimer: This is not advice to buy, sell or hold any stock referenced. Do your own due diligence. I have no position in any stock mentioned in this report. Like any financial analyst, doesn’t mean I’m not biased.

Generally IT security is implemented by multiple security products, which is known as a defense-in-depth strategy that involves multiple layers to protect against threats. Qualys has a broad product offering and depending on customer size, some could get by with Qualys alone. For the Qualys Cloud Platform, there’s no hardware to buy or manage and it offers real-time visibility in one place, seamless scaling, up-to-date resources, and secure data storage. 

Qualys is a small-fish in a big pond of the cybersecurity industry that’s seen a lot of growth capital deployed in recent years. Qualys’ main product and strength is vulnerability monitoring. The cybersecurity field includes lots of angles to protect, respond and remediate weakness and some companies take a much more specialized approach. While many large cybersecurity companies can offer a wide range of products, most companies have clear strengths. For instance, while Qualys’ focus is on monitoring and compliance, others focus on network security, endpoint protection (think different touch points connecting to a network) and threat intelligence.

Products: Qualys was founded in 1999 and launched its first application, Vulnerability Management (VM), in 2000. “Many organizations have an array of heterogeneous point tools that do not interoperate well and are difficult and costly to maintain and integrate, making it difficult for Chief Information Officers (CIOs) and Chief Information Security Officers (CISOs) to obtain a single, unified view of their organization’s security and compliance posture.”

Since inception, the company has steadily added applications. The main product for Qualys is Vulnerability Management, Detection and Response (VMDR) which had 48% penetration of its own customer base. Qualys also offers free services which includes the Global AssetView (GAV), Cloud Inventory (CI) and Certificate Inventory (CRI). Customer can subscribe to one or more of the apps.

The following graphic from the Q4’22 investor presentation neatly organizes the product offering list.

Customer: Qualys sells its suite of products to companies of all different sizes, including enterprise and government entities. There’s over 10,000 paying customers, a level it broke in 2021. Before that, Qualys used to provide the customer count that included those using the freemium version, of which there was 19,000 in 2020. Every 10-K dating back to 2013 (the first 10-K) pointed out that the majority of the Forbes 100 was a customer. 

Qualys sells both directly to customers and also through channel partners, such as consultancy companies. In this method, a potential customer who isn’t as sophisticated may work with a consultant, value added reseller or managed security service provider (“MSSP”) as an intermediary. Channel partners make a fee and Qualys then makes a direct relationship. The percent of sales from channel partners has stayed at about 42% annually.

Business model: Qualys has a land and expand business model. Customers initially pay for one or two of the product solutions and Qualys drives growth by upselling existing customers by expanding the scope of solutions and increasing subscriptions into additional applications. This works well given there’s 10,000 paying customers and likely another 10,000 companies actively using the free version, making for a good opportunity to grow.

In addition, Qualys does some bolt-on acquisitions to expand functionality of the platform. Qualys acquired Blue Hexagon in 2022 to enable AI/machine learning to “uncover behavior patterns including active vulnerability exploitation”. The prior year Qualys acquired Kandor Soft Labs to enhance workflow. 

Competition: The IT security field is highly fragmented and Qualys competes against small and large companies in the industry. Those listed the competition section of the 10-K filing include Symantec Enterprise Security, which is owned by Broadcom (AVGO), CrowdStrike (CRWD), Palo Alto Networks (PANW), Rapid7 (RPD), Tenable (TENB) and privately-held Axonius, Checkmarx, Flexera, Invicti, Ivanti, Tanium, Helpsystems (by Fortra), Trustwave and Veracode. 

While describing competition in its risk factor, Qualys notes that some competitors have greater brand recognition, larger pools of resources for marketing, distribution, product development, customer support, and ability to make acquisitions. In addition, some competitors have broader product offerings and can bundle services, allowing customers to pick a bundled suite, and potentially at a lower price. Bundling applications and offerings generally is important in the space and Qualys is trying to become a one-stop shop for security services. 

Qualys has eight mutual peers in its proxy (each company lists each other as a peer): Rapid7 (RPD), Tenable (TENB), CrowdStrike (CRWD), Varonis Systems (VRNS), Five9 (FIVN), New Relic (NEWR), SPS Commerce (SPSC) and HubSpot (HUBS). The first three peers are routinely listed in the competition section of the 10-K. 

Focusing on the competition, Qualys breaks them out by security type in their investor presentation seen below. Some of these such as Crowdstike are currently specialized and have a strength in IT security, with an emphasis on endpoint security. Others have more broader offerings, similar to Qualys.

As you can see, there’s a fair amount of overlap of some of these companies, particularly Rapid7 who also covers IT security, Web App Security and Container Security. Tenable also covers three product lines. While there is some overlap in product offerings between these companies, each has their own unique strengths and focuses. Qualys and Rapid7 both have a strong focus on vulnerability management and compliance, while CrowdStrike and Palo Alto Networks focus on endpoint protection and threat intelligence. 

If you take a look at the graphic below, it adds another important nugget about the cybersecurity market – a lot of the companies are at different business stages and sizes. Palo Alto Networks is the largest by sales and market-cap. Crowdstike and SentinelOne are younger in the company cycle with each still in the hyper and strong growth phase. Crowdstrike had 54% YoY growth last year off a revenue base of $2.24B. SentinentelOne, which debuted in a June 2021 IPO, had 114% YoY growth in 2022. 

The dark horse of the cybersecurity space is Microsoft (MSFT) which has quietly built an enormous business. Microsoft doesn’t breakout the segment on its quarterly filings, however, management occasionally gives the revenue figure in conferences. CEO Sateya Nadella gave an update of the security business in the January earnings:

“Over the past 12 months, our security business surpassed $20 billion in revenue as we help customers protect their digital estate across clouds and endpoint platforms. We're the only company with integrated end-to-end tools spanning identity, security, compliance, device management and privacy informed and trained on over 65 trillion signals each day. We are taking share across all major categories we serve. Customers are consolidating on our security stack in order to reduce risk, complexity and cost.”

The $20B compares to $15B in the prior year, and $10B the year before that. For context, that’s more revenue than all of the peers Qualys listed and it grew at 33% YoY in 2022. 

One data point I do like to see in Qualys versus most peers is the profitability. A lot of the SaaS group sport high free cash flow and high gross margins. When you step down a level on the income statement to operating margins, Qualys fares significantly better than peers, largely due to SG&A and stock-based compensation. The following graphic shows SG&A and EBIT margins for all companies in the software sub-sector, with Qualys highlighted.

Capital Allocation: Qualys has leveraged its solid margin profile into good capital allocation. Over the last 10 years back to 2013, Qualys earned cumulative net income of $504M and free cash flow of $946M. It has spent 19.5% of the operating cash flow on capex, according to the history of cash statements. With the free cash flow left, only 2.8% was spent on acquisitions. The bulk of free cash flow has gone to stock repurchases at 91.2%. Qualys has never given a dividend, opting for buybacks instead. Those headline numbers compare to Palo Alto Network which spent 12.6% of cash flow from operations on capex, 36% of free flow on acquisitions and 58.8% of free cash on buybacks. 

In both cases, the count of shares outstanding has risen, though not as high for Qualys. Palo Alto Networks has seen its shares outstanding increase by 40.1% since 2013 while Qualys’ shares outstanding has only increased 17.6%. The effect here is generally the same. Dilution through stock based compensation offset by some buybacks. Palo Alto Networks did do a noteworthy acquisition in 2020 that was partially paid for in stock. 

Given Qualys’ relative good margins, the company has an ability to repurchase a meaningful amount of shares. I like seeing the company lean into repurchases while still spending 20% of its operating cash flow on capex. Qualys introduced buybacks in 2018 and the outstanding count of shares has reduced since 2019.

Management and Incentives: Qualys has been led by Sumedh Thakar as CEO since February 2021. Thakar is a longtime employee, initially joining the company in 2003 and rising up the engineering ranks. He was promoted to vice president, engineering in 2010, then chief product officer, president and then interim CEO until taking the reins on a permanent basis in April 2021. At 46, he spent most of his career with Qualys. He’s come into the CEO role at a good age and should have a long runway ahead of him. 

Qualys separated the CEO and chair of the board duties in 2021 when Thakar took over from prior CEO Philipee Courtot, an industry pioneer, who stepped away in 2021 for health reasons. Now the chair is Jeffrey Hank who's been on the board since 2010 and was elevated to chairman in January 2023. Hank has a background in accounting and was previously chief accounting officer of Inuit (INTU). 

Joo Mi Kim rejoined Qualys as CFO in June 2020 after working as vice president, FP&A, investor relations and operations from June 2016 to June 2018. She left to take on CFO roles at two other technology companies. 

Unsurprisingly, only a small portion of executive pay is in the form of salary, and therefore +90% of the total compensation is based on performance. Thakar’s salary was 4.2% of his target total compensation in 2021, and other executives were set at 7.2% of their target total compensation. Executives then have a max cash bonus (referred to as non-equity incentive compensation) equal to 50% of their salary, or 100% in the case of CEO Thakar. Qualys has favored quarterly goals for determining payout of cash bonuses. 

“Our Compensation and Talent Committee decided this was the most appropriate measure of time to determine achievement of short-term goals because it aligns with the time periods for which we give external guidance.”

According to the April 2022 Proxy, cash bonuses had goals for 2021 set to bookings growth, revenue growth and non-GAAP EPS. The metrics were the same as 2020, but the calculation of non-GAAP EPS changed in 2021 to better account for stock repurchases, which is nice to see (executives couldn’t hit EPS by juicing buybacks). Chief Revenue Officer Allan Peters, who resigned in February, had different goals that were tied to bookings, with a specific weight given to new bookings and upsell bookings. 

The equity compensation changed in 2021 to begin including performance-based equity awards to non-CEO executives, unlike in prior years where executives other than the CEO received just RSUs. The inclusion of performance-based restricted stock units (“PRSUs”) is a nice inclusion to better motivate leadership. PRSUs will vest based on annual revenue growth and adjusted EBITDA margins. Even though it’s based on a three-year period, the goals for each year are set at the beginning of that year, so it still feels a bit short-term in nature. Thakar was paid an equal amount of RSUs and PRSUs, according to grant date fair value (“GDFV”) while the target value of the PRSUs for other executives was half the value of the RSUs. 

Outlook: Qualys is a relatively mature cybersecurity company having debuted in a September 2012 IPO. Therefore, there’s plenty of historical financials to look at. Qualys has had a fairly steady growth picture. No year has had revenue growth lower than 12.9% YoY (2021) while no year was higher than 23.7% (2015). The growth picture did slow for most of 2016 - 2021, but reversed course and picked up in 2021 and accelerated further in 2022 with 19.1% YoY growth.

The 2023 consensus revenue estimate is $556.3M, representing growth of 13.6%. The 2024 consensus estimate is also expecting about 13.5% growth. Qualys itself issued sales guidance for 2023 of $555M (13.3% YoY) and GAAP EPS of $2.58 (both are mid-points). Note that the growth outlook is softer in 2023 as compared to 2022 largely due to macro headwinds that began to deteriorate growth and bookings in Q4’22. 

Management discussed this on the February 9 earnings call when they delivered guidance. CEO Thakar said:

“We saw the macro and from our perspective, deteriorate in Q4, and that thing that was reflected in are softer than expected bookings, both on new and upsell. And I think we see opportunity for us to continue to work with our sales team, improve their execution and I think -- those are some of the things that -- changes that we have put in place that we are looking forward to. As we get into Q1 and FY '23, we've sort of not assumed any change in that macro or productivity or anything like that when we looked at the guidance.”

The sales execution and productivity could be negatively impacted by the CRO turnover. CFO Kim added,

“We believe our outlook is appropriately derisked from that perspective because if you take -- the assumption that we made in addition to the -- assuming that the current macro continues, is no material gain from the newer product. I mean we do see a huge upside to our guidance if our newer product happened to take off in the second half of this year. However, because of the personnel changes, we believe that the sales rep productivity, even though it was lower in Q4, we're assuming that it continues as it is in 2023.” 

As I look at revenue and try to deconsolidate, there’s not a lot that Qualys offers. The company does breakout Direct sales and Partner sales, and also revenue by geographic split between United States and Foreign. Both have been steady in recent years.

I also like what I’ve read about Qualys from research and advisory firm Gartner, with high ratings in ability to execute and completeness of vision, and ability to scale. Qualys apparently has some subpar customer service, user interface and pricing that’s higher than competitors. 

Personally, I don’t see the growth slowing much over the next five years. This post isn’t really about the trends of the cybersecurity industry itself. But to keep it high level, hackers are continuing to get more sophisticated and the prevention needs to get equally more sophisticated. There’s also more laws being put into place regarding cybersecurity prevention and Qualys is a great service to meet regulatory needs. As more companies are subject to laws such as Health Insurance Portability and Accountability Act (HIPAA), Gramm-Leach-Bliley Act (GLBA) and The General Data Protection Regulation (GDPR), more companies will seek out Qualys' services to help them achieve and maintain compliance. For those looking to performatively check a box for business, Qualys is a great option.

Valuation: My DCF model starts with revenue that’s in-line with the consensus view with growth of 13.5%. Again, there’s a macro growth headwind in 2023 that’s dropping the growth rate from 2022. I’m expecting revenue growth to pick up again in 2024 then gradually taper to 11% in five years. My GAAP EBITDA margin is going to be 35% in 2023 and only move slightly higher five years out. Margins were at 36-37% in 2020 and 2021 so it’s feasible that EBITDA margin can be upwards of 36% in the coming years.

It’s no secret stock-based compensation is a material expense at Qualys with the accounting value coming in at about 10%-11% of the revenue each year. Buybacks have also been significant, as mentioned in the capital allocation section. I’m trying to be more precise with the financial model by estimating the future real cost of dilution and offsetting buybacks. Qualys relies on RSUs and PSUs. When they give RSUs, the accounting cost is based on the stock price at the time of the grant, spread out over the vesting period. If the stock goes up, the real cost to the company also increases. 

I’m applying a similar approach to stock buybacks by estimating Qualys will spend 80% of it’s free cash flow on buybacks (FCF value before buybacks are subtracted) which will in turn reduce the outstanding count. To make sure I'm not double counting, I am also reducing free cash flow by the buyback amount.

The significant assumptions for the DCF model include a discount rate of 10.5%. Qualys actually has a relatively low beta, so this might be on the high end considering the equity risk premium. There’s also no material debt to consider. During the last five years, Qualys has traded at a EV/EBITDA LTM multiple of 33X and currently trades at 24X LTM EBITDA. I’ve opted for an exit multiple of 21X. The conclusion of the DCF model values Qualys at ~$149.00 which indicates potential upside of 15% compared to the current price.

Summary: I enjoyed learning about Qualys and the cybersecurity industry. Every company felt a little different, and I like the margin profile at Qualys and capital allocation. The company appears to be well run with steady growth. While reading the 10-K, and its changes, I was pleasantly surprised by how little change there was. The stock has some appeal with modest upside remaining, even though my DCF is on the conservative side. I’m still not excited enough to make this a buy and I’d instead consider it a market-perform situation.

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Disclosure: This is not advice to buy, sell or hold any stock referenced. Do your own due diligence. I have no position in any stock mentioned in this report. Like any financial analyst, doesn’t mean I’m not biased.

Overview: Sovos is a consumer-packaged food company founded in 2017 with brands featuring Rao’s, Michael Angelo’s and noosa . Current CEO Todd Lachman founded Sovos with the intention of acquiring high-quality brands for premium positioning. Advent International backed Sovos and then floated the company on the public market through a September 2021 IPO that priced at $12.00.

The business model “centers around our premium, taste-led, high-quality brands and leveraging a common infrastructure and shared playbook to drive growth.” according to the 2023 10-K. “Our brands generally over-index with young and family-oriented consumers who have higher disposable incomes.” The growth playbook is focused on increasing household penetration by: 1) increasing distribution, 2) expanding brand awareness; 3) improving sales and marketing execution; and 4) innovating into new categories. Michael Angelo’s and Rao’s were each acquired in 2017, noosa in 2018 and Birch Benders in 2020. Birch Benders was then sold in January 2023, leaving the company with the three initial brands going forward. In the 2022 10-K and 2021 IPO prospectus, the business model was written as “grounded in acquiring “one-of-a-kind” brands”. Considering it was founded to be a roll-up, the change in language is notable as Sovos charts its path forward, which could lean toward capex and internal growth rather than transformative acquisitions.

Brand breakdown -  Roa’s is a maker of Rao’s Homemade pasta sauces. The segment made up 66% of company sales in 2022 (69% excluding pro-forma excluding Birch Benders). Rao’s had 14.7% dollar market share for 2022, up from 13.2% of the pasta and pizza sauce dollar market share in the prior year, making it the number two brand. The high dollar market share is helped by the relatively high price point and the unit share is only 5.6% of the market. Rao’s had 11.9% household penetration, up from just 1.3% in 2016, and ended 2022 household penetration at ~15%. Not only does Rao’s make up the majority of company-wide sales, it also has been the fastest-growing brand at 38% YoY in 2022. The acquisition and execution and execution to date has been a homerun. The following graphic was included in the Q4’22 earnings presentation.

I’m going to sidetrack with an anecdote and talk about the one of the reasons why I decided to write about Sovos. The first reason was my first recent trip to Costco in which my wife grabbed the Rao’s pasta sauce and said “I’ve heard this stuff is really good.” Neither of us had Rao’s sauce before but she’s noticed it come up in online articles ranking pasta sauce. It might be strange that neither of us had Rao’s before, but we’re west coast and the brand got started on the east coast so it’s still growing here. And most of our pasta sauce is homemade. To confirm the quality, though, I searched “top store bought pasta sauce”. The first three hits from Tasting Table, delish and Washington Post all listed Rao’s as the number one pasta sauce.

Now back to Sovos…noosa is the second largest brand for Sovos at 20% of 2022 net sales. The household penetration of noosa in 2022 was 7.5%, a slight dip for the year. In 2021, noosa captured 2.7% of the yogurt dollar market share, ranking it the number 11 yogurt manufacturer. Sovos didn’t provide those figures for 2022.  The brand grew 7.8% YoY in 2022 “driven by the increase in sales of spoonable yogurt” and the new Gelato offering. Michael Angelo’s made up 9% of Sovos sales and grew by 1.9% in 2022. The brand makes frozen, Italian dishes such as lasagna, eggplant parmesan and other pastas. The household penetration also dipped to 4.7% in 2022. Like the other brands, Sovos didn’t provide dollar market share for 2022, though it stood at 1.6% in 2021. Lastly, Birch Benders made up the remaining 5% of company-wide sales. However, the brand is the least impressive of the four and was sold in January 2023 (more on that later). 2022 sales for the segment declined 26.9% YoY, which was chalked up to lost distribution to a key customer and continued demand softening of pancake and waffle mix. .

Sovos sells to warehouse clubs, grocery stores and other food outlets with 99% generated nationally (1% international). The three largest customers in 2021 were Costco (17%, down from 18% in 2021), Walmart (13%, even from 2021) and United Natural Foods (10% down from 11% in 2021). The top five customers together accounted for 53% of total sales, up from 49% in 2021.

Competition: Sovos operates in a “highly” competitive field of the packaged food industry with competition coming from large multi-brand companies, smaller product-focus companies, emerging companies and dairy/dairy alternative-focused companies. The large multi-brand companies consist of B&G Foods (BGS), Barilla Holding S.p.A, Campbell Soup (CPB), Conagra Brands (CAG), Continental Mills, General Mills (GIS), The Hain Celestial (HAIN), J.M. Smucker (SJM), Kellogg (K), Kraft Heinz (KHC), Mizkan, Nestle S.a. and Pepsico (PEP). The smaller product-focused companies are Amy's Kitchen, G.L. Mezzetta and Newman's Own. As for the dairy/non-dairy, Sovos lists Chobani, Danone, Fage International S.A. and The Lactalis Group.

When it comes to Sovos’ money maker pasta sauce, they compete with the largest makers Classico (owned by Kraft Heinz), Prego (owned Campbell Soup) and Hunt’s (owned Conagra Brands). I noted earlier that Rao’s is often ranked number one tasting pasta sauce by some foody publications. However, it should also be noted the price is roughly double those market leaders. Classico goes for $3.50 at my local grocery store whereas Rao’s sauce costs $8.00. If there is some budget tightening, price conscious step-down in the future, it would push customers away from buying Rao’s in favor of other sauces. However, according to CEO Lachman, when consumers need to tighten budgets, Rao’s does well as they absorb the group of customers who were previously dining out and instead save money by buying Rao’s sauce. In a September 2022 conference call, Lachman said: “In times -- recessionary environment, what's the first thing that consumer cuts back on is travel and leisure spending and notably restaurant meals and that they can buy a jar of Rao's sauce and a bag of pasta, and a side salad for $15 and have a restaurant-quality meal versus going out to a chain Italian restaurant and feeding your family for $70.” Then in November 2022 he added, “Consumers are cutting back from out-of-home dining expending and chunks right now, and they want great restaurant quality cuisine and they're buying Rao's.”

The U.S. yogurt market is dominated by Dannon (owned by Danone S.A. with roughly 33% market share), Chobani (privately held and holds ~20% market share) and Yoplait. Dannon has a few brands it sells under in the U.S., including Light & Fit and Oikos. Similar to Rao’s, noosa is also priced at a premium. The local pricing per ounce of Dannon is about 20 cents, 25 cents for Chobani and 28 cents for noosa. Noosa does better on the price point of the larger sizes (24oz for instance) rather than individual containers and this is purposeful. Regardless, a similar picture in buying the premium product. However, in the case of noosa, it was rare for me to find articles online placing it among the best yogurts.

Sovos revealed on January 9 that it sold Birch Benders to Hometown Food (Hungry Jack pancake owner). Lachman said in the press release that the announcement “reflects Sovos Brands' continued commitment to growing our core Rao's and noosa brands and, in particular, accelerating Rao's to $1 billion in net sales and beyond. As we look ahead, Sovos Brands will be a more focused business that is better-positioned to drive sustainable sector leading growth for years to come.” Before the sale, in Q2’22, Sovos took notice of the underperformance of Birch Benders and took an impairment charge of $42.1M, which is equal to about 29% of the 2020 purchase price of $146M. Cash received from the sale was $40M so the company took another $51.3M loss on the asset. Relative to the success in acquiring and growing Rao’s and noosa, the Birch Benders acquisition is quite a blemish for the Sovos team.

A comparative financial analysis with Sovos and its peers shows that SOVOS has a similar margin profile at nearly 30% gross margin, despite the premium pricing. It’s nice to see the momentum in the brand with growth TTM growth at 22%, which is 2X its next named competitor. Moreover, Sovos is projected to grow 10% organically in 2023.

Capital Allocation: The common ways to spend capital consist of internal growth (capital expenditures), external growth (acquisitions), dividends and buybacks. Given Sovos was founded in 2017 and still in the growth phase of its life, the capital allocation priorities are unique compared to peers in that it had previously been heavily weighted toward acquisitions.

The IPO prospectus for Sovos offered financial data back to 2019. Since then, Sovos generated $167 in operating cash flow of which 26.0% went toward capex. That left Sovos with cumulative FCF of $123M through 2022. The single acquisition during this period was for $146M (Birch Benders), which it divested for $40M. Other capital allocation activity consists of a $400M dividend and share issuance of $309M. Those two moves were about changing the capital structure and paying PE backer Advent.

Sovos carried total debt of $361.2M at the end of 2022, and notes it has a net debt to (adjusted) EBITDA of 2.9X. The adjusted net debt to EBITDA is 3.9X, which is in-line with its peers that average 4.1X leverage. The debt-to-equity ratio is slightly lower than the peer average. Due to the nature of the growth at Sovos, it’ll grow into the leverage ratio, giving it room to take on more debt.

Management and Incentives: Sovos has been led by Todd Lachman since 2017. Spent two years in private equity before founding Sovos. Before that, he was global president of Mars Petcare, president of Mars Chocolate North America and in various positions at Del Monte Foods and other large consumer packaged goods companies.

William Johnson is chair of the board and has been an operating partner of Advent since 2014. Johnson’s significant corporate work consists of being COO H.J. Heinz Company (Kraft Heinz predecessor company) beginning in 1996 and served as CEO from 1998 until it was sold to Berkshire Hathaway and 3G Capital in 2013. That includes overlap with Lachman who was managing director of pet products for Heinz from 2000 - 2003. Before that Johnson was with household cleaning products company Drackeet and animal food company Ralston Purina.

Compensation details for 2022 haven’t been disclosed yet (2022 proxy was filed on April 25). For 2021, Lachman was paid 5.3% of his total compensation in salary and 86.6% was paid in the form of stock. The next two executives, CFO Chris Hall and Chief Commercial Officer Richard Greenberg, were paid 76% of their total compensation in stock. Non-equity incentive compensation (annual bonus) made up 5-6% of the total compensation for each of the three named executives. In all cases, the 2021 stock award portion of total compensation was elevated due to irregular grants in connection with the IPO. It also included an increase in the accounting value of a modification of pre-IPO stock.

Non-equity incentive compensation has top-line and bottom-line targets for achievement, namely net revenue, adjusted EBITDA and adjusted cash flow. There was first half 2021 targets, second half targets and full-year targets. The full-year 2021 targets were revenue of $719.3M, adjusted EBITDA of $122.2M and adjusted cash flow of $39M. Together they paid out at a percentage of 93%. Sovos started trading in September 2021 and guidance was given after that in November 2021 for FY2021 of $712.5M for revenue and $114M for EBITDA. The guidance was achieved but the EBITDA compensation goal was missed. Note that the second half adjusted EBITDA target had a payout percentage of 0%. However, the compensation committee used its discretion to payout at 75%. This is not something you want to see as an investor. Why have compensation goals if they’re not going to be upheld? Sovos wrote in the proxy:

The Company faced significant headwinds during the second-half performance period, including due to exogenous pressures such as inflation, resulting in below-target adjusted EBITDA that would have resulted in a $0 payout for the second-half performance period. However, in consideration of the team's tenacity and agility in managing the Company through a challenging period, the successful completion of the IPO, the Company's overall performance as compared to other CPG companies and the competitiveness of the talent market, the Compensation Committee approved a payout of 75% for the second-half performance period.

The stock-based compensation is paid out in the form of time-based restricted stock units (“RSUs”) and performance-based restricted stock units (“PSUs”). Before the IPO, Sovos gave out RSUs and PSUs with the latter vesting based on the MOICs of Advent’s exit, which include selling shares. The hurdles were 2.0 MOIC to 4.0. Then in connection with the IPO, Sovos gave out IPO Equity Grants that were RSUs and PSUs with the latter vesting based on the average stock price during the following three years as compare to the 20-day VWAP immediately after the IPO. 25% vesting upon achievement of a 25% increase over the baseline and 100% vesting for a 100% increase over the baseline. The 2022 proxy also noted that the 2022 grants were 40% RSUs and 60% PSUs. However, Sovos didn’t disclose the performance conditions, which isn’t unusual of a company to disclose until the subsequent year. The PSUs didn’t show up on form 4s either so it’s unclear what the financial motivation will be going forward.

Fast forward to February 10, 2023, Sovos disclosed that they amended the IPO PSUs and pre-IPO PSUs by replacing them with time-based RSUs. I like to see companies tie the vesting of some PSUs to stock so it’s a little discouraging to see Sovos simply remove those targets.

Outlook and Consensus Estimate: There’s 12 analysts covering Sovos and the average 12-month price target is $17.50. 11 of the 12 rate Sovos either a buy or strong buy. On March 9, management gave 2023 guidance of $912.5M and adjusted EBITDA of $132.5M (midpoint). Reconciliation of adjusted EBITDA for 2022 removed significant transaction cost and impairment costs that won’t be a factor for 2023, but it did also remove stock based compensation and there’s no reason to believe Sovos will stop handing out SBC. As of March 23, the 2023 consensus estimate for revenue is $918.9M (4.6% growth; 9.7% organic). The 2024 estimate is $985.6 (7.3% growth). Consensus EBITDA for 2023 and 2024 is $132.7M and $1146.4M.

Much of the growth in recent years has come from Rao’s and there’s a combination of volume and price mix driving the growth. Of the 19.5% organic growth in 2022, more than half, or 10.8%, was driven by volume as Rao’s captured more market share. 8.7% was driven by price increases, which compares to 2022 food-at-home inflation of 11.3%. Most peers, on the other hand, drove top line growth by price increases. The following graphic shows 2022 and Q4’22. I don’t put much weight on the Q4’22 figures because volume growth has fluctuated throughout the year based on promotions.

Assuming inflation cools in 2023 and beyond, growth via price increases will be more minimal. After all, how much more can Sovos really charge for Rao’s pasta sauce and noosa yogurt. I’m the exact target audience that  Sovos listed in the 10-K and I have my limits on +$8.00 pasta sauce. I do think there’s more room for growth via volume and market share capture. I’m also intrigued by the increase in product offerings. Rao’s is launching frozen pizza in 2023, Michael Angelo’s will produce its own sauce to split the price point of Rao’s and leading competitors, and noosa added gelato in 2022.  I deconsolidated revenue by brand to produce estimates for the next five years that look as follows.

Valuation: I used my revenue estimates above to open up a DCF model. Sovos has a similar margin profile to most peers and I don’t think that’s going to change significantly. Sovos had better margins before high inflation set-in during 2020, compared to the current margin profile. The company has been playing catch-up in getting back to gross margins above 30%. As the company continues to invest in productivity, I expect margins to tick higher over the next five years.  The DCF begins with EBITDA margins at 14.0%. As the company grows more in the coming years the EBITDA margin should tick higher and settle at about 15.0%. Free cash flows for DCF look as follows.

My other critical assumptions are as follows: a discount rate of 10.0%, which seems fitting for the capital structure and relatively low beta, which is 0.75 according to data providers. The 2023 growth is actually similar to the 2026 growth because Rao’s will make up more of the pie by then and will have higher growth than noosa and Michael Angelo’s. Sovos currently trades at 16.7X LTM EV/EBITDA and 15.2X forward consensus estimate. The DCF model exits at a LTM EV/EBITDA multiple of 14X. The summary is as follows.

While it’s nice to apply some numbers and see how the DCF model looks, I don’t necessarily think the financial outlook is going to be a simple gradual decline to a terminal steady-state. The business was launched as a small roll-up of acquiring premium consumer brands and it’s unclear if Sovos is done adding to the portfolio. The balance sheet has a solid cash position of $138M (about 10% of the market-cap). And since they are profitable and growing, they could easily afford a meaningfully sized acquisition in the next one or two years. Sovos could build up its free cash flow and buy a company for $200M or more with some added debt. If that’s the case, the income statement and growth could look materially different.

On a simple relative valuation basis, Sovos stacks up well compared to peers. As noted, Sovos currently trades at about 15.2X EV/EBITDA NTM. If you take a look at the peer group of companies making similar products shown in the comparative financial analysis section, the average forward EV/EBITDA is 12.2X for companies expected to grow 4.0% on average in the next twelve months (data from Koyfin). However, Sovos is expected to grow 10% organically in 2023 off 22% growth in 2022 so it does deserve a higher multiple. Other consumer companies with similar growth profiles and margins include Vita Coco (COCO), Bellring (BRBR), J&J Snack Foods (JJSF) and Utz Brands (UTZ). Those four trade at an average EV/EBITDA NTM of 16.7X with average expected growth of 11.4%. If you price Sovos based on 15X forward EV/EBTIDA, with EBITDA next year around $130M, it would imply a fair value price of $15.90. The stock has jumped about 25% over the past month and quickly grew into fair value territory post earnings, leaving no upside left.

Final thoughts: Sovos has generally executed well in recent years and I expect the management team to continue to grow Sovos. The internal growth has been exciting as Sovos hit it out of the park on Rao’s execution and the product additions are encouraging for continued growth. The DCF model values Sovos at $16.54 and current relative valuation assumes it’s worth $15.90 per share. I’d split the difference and value Sovos at about $16.00 so the stock is trading right at fair value.

Disclosure: This is not advice to buy, sell or hold any stock referenced. Do your own due diligence. I have no position in any stock mentioned in this report. Like any financial analyst, doesn’t mean I’m not biased.