MNBEF - Alps Alpine Executing On Sales But Margins Still Lagging

Summary

• Alps Alpine has continued to outperform on revenue, helped in part by currency, but has struggled to execute on margin improvement efforts.
• I'm not concerned that a transition to new camera actuator technologies will disrupt the business; management has seen tech transitions before.
• The auto business is a jumble, with good performance in switches and sensors, but lagging performance in infotainment and a lot of uncertainty about sustainable long-term operating margin.
• Alps Alpine looks undervalued on what I believe are low expectations, but it will likely take improved visibility on margin leverage to drive a more meaningful rerating.

The story on Alps Alpine ( APELY ) (6770.T) when I last wrote on this Japanese electronic components company was relatively straightforward - the company had a strong business in components for smartphones and autos but needed to demonstrate that it could leverage those capabilities into new growth markets and drive better margins. Though the story was straightforward, the execution has been anything but, as the company has had some notable successes in some areas and significant shortfalls in others.

The local shares are up about 20% since my last update , but a strong dollar has driven the return for the U.S.-listed ADRs slightly into the red. Even so, the ADRs have outperformed rivals and comps like MinebeaMitsumi ( MNBEY ), Knowles ( KN ), NXP Semiconductors ( NXPI ), and Sensata ( ST ). I don't find the valuation particularly demanding now, but management needs to dig deep and prove to investors that it can leverage technological and market leadership into worthwhile margins and cash flow.

A Mixed Quarter With Familiar Notes

Alps Alpine has built a strong track record of better-than-expected quarterly revenue reports, with the company beating expectations several quarters in a row, but margins continue to prove stubbornly weak.

Revenue rose 9% as reported and closer to 1% on an adjusted constant currency basis, beating by about 3%. Growth in the components business (including camera actuators and haptic motors) came in at 5%, with decent growth relative to the underlying smartphone market. Sensor and Communications revenue rose 7% as growth in auto sensors offset some weakness in smartphones, and Module & System revenue jumped 36%, helped by forex and improved auto production, as well as new wins.

Gross margin improved 60bp yoy and declined 80bp qoq to 20%, with material cost inflation still impacting the company in a significant way (particularly in the Module business). Operating income fell 16% and missed by 12%, with margin down 180bp yoy and 140bp to 5.9%. While the company has consistently beaten sell-side revenue expectations, the track record is far less consistent on the operating side, and margin assumptions have continued to fall.

At the segment level, Components profits declined 7%, with margin down 140bp to 15%, while Sensor & Communications profits were down sharply, with margin down 170bp to 0.8%. The Module business reversed a year-ago loss, but the margin is still a very dilutive 0.1%.

Prepping For New Camera Demands

One of the perpetual concerns around Alps Alpine is that the company will eventually lose leadership in leading-edge camera actuators, even though transitions to new technologies have usually been favorable to the company's market share and margins. So it is again now, with some analysts worried that a move to Shaped Memory Alloy (or SMA) actuators and Piezoelectric actuators will drive meaningful share loss.

Of course, time will tell, but Alps has introduced new SMA and piezo products that seem very competitive to what's available in the market, and the company has enjoyed a good long-term relationship with Apple ( AAPL ) - while Apple can be brutal on its suppliers, the company does generally stick with suppliers when they consistently develop better mousetraps. At the same time, the company has been working more closely with Chinese OEMs to grow its business there.

I am concerned about likely weakness in smartphone unit volumes in 2023, but I think a transition to new camera actuator technologies can help offset that risk.

The Auto Business Is A Jumble

Analyzing Alps' performance in its large auto business is anything but simple right now. The company's core switch and sensor businesses appear to be performing well, particularly with improved volumes.

New opportunities in in-cabin sensing (like a mmWave-based sensor that alerts drivers if they've left a child in the car) are ramping and the company has also secured wins for sensors tied to inverters and battery management systems for electric cars. I continue to see significant opportunities with the sensor business, ranging from ADAS (detecting road hazards and road features like lane markers) to in-cabin (presence and condition sensors, as well as capacitive touch sensors) to operational (including temperature and position sensors for EVs).

The infotainment part of the business has had more issues as the company has tried to transition from traditional in-car navigation and audio offerings to a "digital cabin" concept. The marriage of Alpine's audio capabilities with Alps' sensor/mechatronic capabilities was supposed to be combining peanut butter with chocolate, but so far it's been more like chocolate and gravel, as wins haven't ramped as quickly as hoped, and development/launch costs gobble up the profitability of the sales they are making.

Management has said the right things about improving margin discipline in this business, including culling unprofitable products/businesses (which is still somewhat unusual for Japanese companies), but this remains very much a work in progress and the strong relative technology positions of both Alps and Alpine have yet to create that "Wonder Twin powers, activate!" synergy.

The Outlook

My expectations for Alps Alpine have never been particularly high, due in part to the fact that there are significantly slower-growing legacy businesses to balance opportunities like auto human-machine interfaces (or HMI) and advanced sensing. Likewise, sustaining profitability as a supplier of the smartphone and auto OEMs has never been particularly easy.

I'm still looking for long-term revenue growth close to 4%. On the positive side, Alps Alpine has meaningful exposure to a lot of auto components that won't go away with electrification, as well as new EV/BEV-specific opportunities, and underrated exposure to industrial Internet of Things (or IoT) growth through its sensing portfolio, and possibly industrial automation/electrification through its HMI capabilities. There are also still upside opportunities for the digital cabin concept.

On the negative, I don't expect outsized long-term growth in the smartphone components businesses, share loss in the transition from mechatronic to electronic controls is possible, and legacy auto infotainment continues to fade.

Alps Alpine actually hasn't really disappointed relative to my own margin assumptions (I guess this is a benefit of conservative modeling). Even so, I'm only looking for around one point of EBITDA margin improvement from FY'22 to FY'25 and less than that with operating margin. Management is targeting an 8% operating margin for the 3/25 fiscal year (the year ending in March 2025), but I see almost no chance of that happening, and the 10% target for 3/28 likewise seems optimistic. Consistent with recent quarterly performance, though, I have little concern about them hitting the JPY 880B and JPY 1T revenue targets (I'm actually about 7% ahead of the former).

Long-term free cash flow margins in the 3% range won't impress anyone, but do still represent some improvement from recent levels in the 1%'s and would still drive adjusted FCF growth of around 8%.

Discounted cash flow suggests that the shares could be around 10% undervalued, and that's using what may prove to be conservative margin assumptions and a higher discount rate than a company with Alps' market shares would otherwise warrant.

Multiple-based approaches don't really work right now; relative to what the market has historically paid for given levels of margin, ROIC, and ROE, the fair value would be considerably higher than today's price, but this methodology doesn't work as well at the extremes (very low or high margins, et al.). The best I can do here is to say that if Alps Alpine traded at the same forward P/E as Sensata (a player in auto sensors and controls), the fair value would be about 40% above today's price.

The Bottom Line

I admit to very mixed feelings about this stock. On one hand, the company is executing pretty well in a lot of areas, and I like the leverage to long-term growth in sensors, switches, HMIs, and so on. On the other hand, the infotainment side has been a disappointment, and I'm not sure how much longer it will drag on results. I don't see the situation getting much worse from here, though, so while this isn't a robust call, I do still see enough upside to make this a name worth consideration.

Readers can find my recent articles on Knowles, NXP, and Sensata by clicking here , here , and here .

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