2023-09-03 03:34:24 ET
Summary
- The company is benefiting from increased defense spending and modernization efforts, providing stability and growth opportunities.
- KEY's investment in development and technology leadership positions it as a leading player in the testing segment.
- Keysight's opportunities in the commercial communications market, particularly in 5G and upcoming 6G cycles, position it for long-term growth.
Thesis
I believe Keysight Technologies, Inc. ( KEYS ) is well-positioned to gain market share, increase customer spending, and grow its software and recurring revenue segments, leading to margin expansion. Keysight's emphasis on R&D testing makes it relatively resilient compared to production and field testing during economic downturns, as customers tend to maintain R&D spending while cutting back on production and field expenses. Several strong demand drivers in the communication solutions space, particularly in the 5G cycle, such as different 3GPP standard releases and Private 5G networks, are contributing to substantial secular growth even before the 6G cycle ramps up.
Company Overview
Keysight Technologies is a manufacturer of testing equipment for a broad eco system of devices that are calibrated to standards specific to their industries, primarily the wireless equipment sector, where the standardization and evolution of protocols led to a market opportunity in calibrating equipment. In FY22, the company posted a revenue of $5.4 billion, serving over 30,000 customers in more than 100 countries. Keysight holds the top market share position in testing equipment for communication technologies and also dominates the market for testing equipment in other sectors, including Aerospace & Defense and Automotive. Keysight's solutions serve as a critical piece in the development and deployment cycles of key technological shifts and long-term secular growth trends that span 5G wireless, next-generation automotive (ADAS and EV / AV), wireless and wireline networking, IoT, and defense modernization.
Market Share Overview
Due to both the expansion of the end markets and Keysight's strategic acquisitions, the company now addresses a combined Serviceable Addressable Market ((SAM)) exceeding $20 billion. Evaluating Keysight's market shares across its various segments is a difficult task, however, it is evident that the company has consistently succeeded in increasing its market presence. Currently, Keysight holds a combined market share of approximately 26% across its target markets. Moreover, Keysight is the number one player in all three of its key markets. While market share growth tends to be gradual in the industries Keysight operates in, I believe the company will continue to capture a larger share in the coming years due to its strengthened customer relationships. This progress is driven by an expanding range of products and solutions catering to the entire customer workflow and the company's commitment to establishing an early foothold in emerging growth areas.
FQ3 Result and Outlook
KEYS reported Q3 revenue and EPS in line with their guidance, but faced a 6% sequential drop in orders due to weakening demand. Notably, Automotive and Aerospace & Defense segments remained strong, while Commercial Communications struggled, and Semiconductor demand showed signs of decline. This marks a worsened trend from the previous quarter, with orders down 6% quarter-on-quarter and 15% year-on-year. The backlog that cushioned against such weakening demand has largely been used up, leaving little buffer.
Around 8% of the order book now consists of long-term projects that won't contribute to revenue until late 2024 or 2025, worsening the near-term order book situation. The deterioration in sequential orders is attributed to China's economic slowdown, impacting both the general electronics and semiconductor aspects of KEYS' business, given its exposure to China.
Despite the declining demand, the management anticipates approximately 7% growth in EPS for FY23, even with just around 1% growth in revenue (toward the lower end of their initial guidance for low single-digit growth), showcasing management's efficiency in cost control amid weak demand.
Despite the decline in overall demand, the Aerospace and Defense as well as the automotive segments are still performing well. The company's software and services sector continues to show year-on-year growth, and the planned acquisition of ESI will enhance the company's software capabilities. Additionally, this move is expected to expand the A&D and automotive businesses. Once the acquisition is finalized, it should positively impact the gross margin due to the software portfolio it brings. Despite the ongoing weakness in the Commercial Communications segment, management noted that this division remains stable, with a greater emphasis on production tests rather than research and development plans. A&D, automotive, and general electronics segments all achieved record revenue in Q3, indicating its sustained strength.
Accelerating Global Spend Environment
Given recent geopolitics, both the US and allied nations have indicated a step-up in defense spending, with a heightened focus on defense modernization and space investments, particularly in the US. Roughly half of KEYS's A&D business is in US. I do not view this step-change in defense spending as partisan and expect continued political alignment on the matter, especially in terms of defense modernization.
Within the US defense budget, modernization allocations, specifically the RDT&E line item within modernization, are key drivers to KEYS' A&D business and focus areas for the company. The Biden Administration proposed FY24 budget request of $842 billion to Congress for the Department of Defense on March 9, 2023, with $315 billion allocated to Modernization and, within that $145 billion to RDT&E. I view this higher level of defense spending across a broader range of customers to provide greater visibility and stability for the business and stabilize the mid-single digit (to potentially low-end of high-single-digit) growth.
Positioned for Growth in the Commercial-Communications Market
Keysight's opportunities in wireless remain robust, even with the initial 5G coverage rollout in the latter stages. This technology is different than prior generations due to the amount of spectrum allocated and the ability to disaggregate the hardware and software layers of the network, adding complexity and more potential pain points that require testing and monitoring. The emergence of virtualization, such as open and virtualized radio access networks, has created new growth possibilities for hardware and software testing gear. The industry is still in the early innings of 5G, but planning is already underway for 6G wireless. Keysight has started to lay the groundwork to play a leading role in the test segment by investing in development and weighing in on early standards.
Moreover, I believe the breadth and depth of Keysight in testing gear, paired with its technology leadership, could allow for multiyear share gains in the commercial-communications market. Although the segment may appear to be closely tied to the global 5G ramp-up, I believe this view discounts Keysight's exposure and strength in other long-term growth areas, such as high-speed telecom and data-center networks, edge compute, artificial intelligence and chip innovations. The expansion of the communications industry and the emergence of new applications have helped increase the opportunities for test equipment and Keysight's scale has allowed it to diversify R&D investments to pursue new fields and grow faster than the underlying market.
Valuation
Keysight's healthy balance sheet and free-cash-flow generation should help it weather an uncertain economic backdrop. It has $2.7 billion in gross cash, and operational discipline could put it on pace for $1 billion in free cash flow in fiscal 2024, allowing it to aggressively buy back shares, fund small M&A or pare debt. Thus, I view KEYS's A&D business as more macro-insulated than other segments of the company and believe the segment's durability is underappreciated by the market. I expect greater stability from KEYS's A&D business vs other segments of the company due to KEYS's focus on the RDT&E/modernization line within defense budgets. The need for defense modernization is now a global imperative to not only the US but also its allied nations.
KEYS is currently trading at a forward PE of 16x, below the sector median of 24x. The company's multiple has compressed following F1Q (Jan-end) order slowdown as investors have been anxious about the lack of a proven track record around execution in a downturn. However, I believe the current valuation multiple reflects an attractive entry point for investors into KEYS shares. I believe a higher multiple is justified on account of Keysight's technological leadership, leverage to multiple industry drivers and market-leading position.
Investment Risks
The test and measurement market is highly fragmented and competitive, featuring numerous players, including well-established companies like Anritsu and Rohde & Schwarz, with substantial resources. The potential for increased competition, driven by factors such as new product launches, shifts in strategies, or aggressive pricing tactics to gain market share, could impact the company's performance in the future. Moreover, heading into the second half of the year, macroeconomic conditions continue to pose challenges. Although the company's commentary suggests relative stability in order trends with typical seasonal patterns, the management has maintained a cautious outlook due to the persisting macro pressures.
Conclusion
In the commercial-communications market, KEYS continues to have strong opportunities in wireless technologies, including 5G and the upcoming 6G cycle. The company's investment in development and technology leadership positions it to play a leading role in the testing segment. KEYS' diverse testing gear and exposure to other long-term growth areas, such as high-speed telecom, data-center networks, edge computing, artificial intelligence, and chip innovations, further enhance its potential for multiyear share gains in the communications market. I believe the expansion of the communications industry and the emergence of new applications create ample opportunities for Keysight's test equipment, enabling the company to outgrow the underlying market. I view the stock as a buy and consider the current valuation multiple as an attractive entry point for long-term investors.
For further details see:
Keysight: Well Positioned In The Communications Industry