There are two central parts of our Short thesis on KEYS.
- Not much of a grower as crowded, low barriers industry competes out incremental opportunities
- KEYS was never a giant FCF generator, and forward #s are miscalculating the impact of Ixia to OCF
This quarter neither of the central thesis points will be self-evident, as:
- Revenue will be in-line, and revenue guidance will be ~2% ahead
- An OCF reversal will make the stock look like a 5% FCF yield on run-rate FCF (4% on Half year annualized)
WHY
- Revenue: it’s just M&A!
- Recently acquired ScienLab
- Plus: flat y/y KEYS
- Plus: flat y/y IXIA
- Plus: ANITE back up to pre-acquisition levels
- OCF:
- ~$17m acquisition related costs in F3Q do not reappear in F4Q GAAP net income
- Working capital reversal from 1H FY17 continues into F4Q
Explanation
M&A will rule the day this quarter. The recent ScienLab acquisition puts Oct-Q revenue a smidge above Street. For the out-quarter, if we just take flattish core KEYS revenue, add in flat Ixia revenue (it will fall but not on current Q, in our view), add in ScienLab, plus ANITE back to pre-acquisition revenue it nets us to ~2% beat on Street F1Q18 revenue expectations. While we are not 100% on all of the moving pieces, the fact that FLAT M&A based revenue will net a beat, and the fact that the other sellsiders will celebrate that as a victory (and are happy to let their bankers collect a check without looking too deeply at this pig), means it is not the right Q to press the Short.
Is it growth? No. It is M&A pixie dust. But the Street won’t have a clue at the time that they report and guide, and our thesis won’t work until deterioration is visible.
Net: not going to get paid on the Short this Q, and we are putting the stock on the Bench until after EPS.
If you are buying KEYS on this Q, keep in mind a few items:
- Under-funded pension obligations mean a 1H F18 cash outflow that will dent expectations
- IXIA flat y/y revenue (our est. for F4Q) is ok for now, decline ahead means deeper fall in estimates versus topline and FCF, AND, will force management to buy more companies to fill the hole
- ScienLab acquisition offsets more than ~half of the intended $60m cost reduction as 200 headcount reduction in KEYS is offset by the acquired 112 employees in Germany in a high cost region
If you are buying KEYS for the 5G ‘pop’, keep in mind:
- 4G was actually a very good cycle for KEYS (in their own words, at the time). The best 4G year for KEYS was 2014 when 4G growth drove an incremental $45m in total topline revenue in F14 and growth of 1.5% for the entire company. 5G will be bigger, but expectations for revenue in 5G have quite a bit of hype in them.
- Total commercial communications revenue for KEYS in F17 looks like just north of $1b, of which 5G was likely less than 15%. Do you know what else is in there? It is not just 4G. There are some ancient puzzle pieces like comms infrastructure, broadband communications, smartphone test (small), and a mixed bag of data center exposure.
- And remember – they are not the only company providing test & measurement tools for the 5G era!
Bottom-line: KEYS is a company struggling to grow organically, in a heavily competitive market where new demand opportunities are quickly eroded by competition, where new technologies imply greater commoditization and position KEYS poorly, and where management is trying to fill a growth hole by acquisitions. The next series of topline misses look like F2Q18 to F4Q18, and we see FCF in F18 of $350-400 missing expectations badly. We also think investors will get disappointed along the way as balance sheet de-levering leads to more M&A rather than cost reductions and buybacks.
As one of the oldest companies/products in Tech if you told us KEYS was worth 10-15x EV/FCF we might not make a big stink about it. At 15x our estimate for forward FCF the stock would be in the $25 range. It’s coming...just not this quarter.
