Technology keeps advancing and becoming more complex and intertwined. With the rise of 5G, we get an abundance of new Internet of Things (“IoT”) use cases and 6G is just around the corner. Technology is increasingly penetrating every part of our lives, and we expect it to work. To ensure that our technology is running as expected, we need Testing and Quality assurance. Keysight Technologies (NYSE:KEYS) is the leading player in Testing applications and has vastly outperformed the market over the last decade. Let’s see what the recent investor day held in the cards for the company.
A growing industry
Keysight operates in three main segments:
- Commercial Communications is the largest segment, with $2.6 billion in FY22 revenues. The market is expected to grow at a 4-6% long-term growth rate and KEYS holds a 27% market share.
- Aerospace, Defense and Government is the smallest segment with $1.2 billion in FY 22 revenues. The market is expected to grow 3-4% long-term and KEYS holds a 23% market share.
- The Electronic Industrial segment is $1.6 billion in revenues in FY22 with a 4-6% long-term growth rate and a 27% market share for Keysight.
Keysight operates in three large and moderately growing markets with much competition. They are the leading player in all three segments, according to their estimates. In the past, Keysight has gained market share and expects to continue doing so by 100-200 basis points per year.
As mentioned in the introduction, there are several secular tailwinds for technology to keep advancing and an increasing need for Testing applications. Some trends that will move trillions in investment over the next decade are next-generation of connectivity, computing (cloud, edge, etc.), semiconductor innovation, digital health, autonomous systems and electrification.
The core sales for Keysight are physical solutions for testing purposes in analog and digital domains. This type accounts for 70% of sales and can be seen as the company’s legacy business. Protocol accounts for 25% of sales and includes simulations of real-world systems to test situations that can’t be tested under real circumstances in a lab. Think about a sensor for a high-speed train going 200 miles per hour or a control system for a satellite. These systems require simulation and Keysight has a vast portfolio of solutions here. Lastly, Applications account for just 5% of sales and include Software and Service solutions in adjacent verticals where Keysight wants to expand. An example is Keysight’s expansion into the Electronic Design Automation [EDA] software market, which is dominated by Synopsys (SNPS) and Cadence Design Systems (CDNS); I recently wrote an article about Synopsys if you want to read more about this industry. EDA Software is used to design semiconductor designs before they are manufactured.
Culture as a competitive advantage
KEYS cites its culture as a competitive advantage with its Keysight Leadership model, focused on Customer success and growing its employees. A significant focus is laid on having and retaining highly qualified employees with many career development programs inside the company. This led to some impressive retention numbers, where the average turnover is just 7% versus the industry average of 13%. An inclusive culture is crucial if you are an acquisitive business like Keysight. 3200 new employees joined as part of acquisitions and 99.5% stayed with Keysight, according to the company. Product development and R&D are a big focus for Keysight (16% of sales) and they need these qualified employees to increase their competitive advantages in a highly competitive market.
A disciplined Capital Allocation Framework
Keysight is a highly profitable company that produced over $7.2 billion in operating cash flows and $6.1 billion in free cash flows over the last decade. With that in mind, let’s look at the company’s capital allocation priorities. The highest priority is driving organic growth. As mentioned above, the primary source of this is via R&D, which uses 16% of sales and thus is a substantial investment. The company also spends around $200 million annually on CapEx to increase its capacity and stay competitive.
The second part of the capital allocation strategy is M&A, where the company acquired 20 companies in the recent past and spent $3 billion in Cash over the last decade. While statistics show that most M&A deals destroy shareholder value, I believe that companies with fleshed-out M&A strategies and a track record of successful bolt-on acquisitions can be successful with an acquisitive strategy. Keysight has strict criteria for its acquisitions to make sure that it fits the strategy by increasing the market and portfolio of solutions, getting new talent into the company and with a focus on high software content or high recurring revenues. Generally, Keysight is looking to increase its software and services part of sales, which currently stands at just 33% of sales. Besides the strategic fit, companies also need to grow, have a high gross margin and generate a Return on Capital above their cost of capital. These are good criteria if management walks the talk.
The last part of the capital allocation strategy is share repurchases, which are predominantly used to offset dilution and are sometimes used opportunistically if the price is right. Due to its acquisitive and dilutive nature, Keysight has increased outstanding shares by 7% over the last decade, mainly due to an 8% dilution in 2017 as part of an acquisition.
Keysight looks like a buy
To value Keysight, I’ll use an inverse DCF analysis with a 10% discount rate, a 3% perpetual growth rate and assuming a modest share count reduction of 0.5%. The company has a clean balance sheet with $200 million net Cash and a $700 million revolving credit facility available if needed. With the current Free Cash flows, the company would need to achieve 10% growth for the first five years, followed by 9% growth for the next five years.
Comparing these growth rates with the long-term guidance issued at the investor day shows that expected organic revenue growth is just 5-7%, significantly below the 9-10% required growth rate. We must remember that Keysight expects to increase operating margins to 31% (these are just operating margins and include expenses like Stock-based compensation) and repurchase shares. EPS growth, a good proxy for Free cash flow per share growth, is expected to be above 10% due to the margin expansion and accretive M&A. In the past, Keysight also achieved a free cash flow conversion of over 100% in most years. To conclude, Keysight operates in a competitive market with secular tailwinds driving modest industry growth. The company is well-managed and offers an attractive valuation without too much growth priced in and a good chance to continue outperforming the market.