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We Think Keysight Has Locked Up a Wide Moat With Its Communications Testing Dominance; $170 FVE We Think Keysight Has Locked Up a Wide Moat With Its Communications Testing Dominance; $170 FVE William Kerwin Analyst Analyst Note | by William Kerwin Updated Oct 12, 2021 We are initiating coverage of Keysight Technologies with a wide moat rating, stable moat trend, and a fair value estimate of $170 per share. Shares appear fairly valued to us. We think Keysight is the leader in communications testing and measurement solutions, and offers a vendor-agnostic way to invest in the rapidly growing 5G market. In our view, Keysight has the strongest and broadest communications testing capabilities in the market, inclusive of hardware, software, and services. Following a sharp rebound from COVID-19 disruption in fiscal 2021, we anticipate 6.5% growth for Keysight through fiscal 2025. We anticipate the greatest growth out of the commercial communications market as Keysight acts as an integral partner to OEMs and suppliers for 5G network buildouts. We also expect a mix shift toward software and services to expand profitability--we expect non-GAAP gross margin to expand to 67% in fiscal 2025 from 65% in fiscal 2020 and forecast non-GAAP operating margin to expand to 32% from 25% over the same period. Keysight should continue to dominate the communications market, especially as it pivots toward more complex 5G testing in which Keysight is already demonstrating proficiency. We forecast market share gains for Keysight and think greater complexity in 5G networks will expand its wallet share at customers--both of which would result in continued outperformance above the underlying testing market. We expect the firm to continue shifting customers to subscription billing for its software and services, and think it will complement continued organic investment with strategic M&A to further build out its software portfolio. Finally, we forecast Keysight to continue generating impressive cash flow and to send a large proportion of it back to shareholders. Business Strategy and Outlook | by William Kerwin Updated Oct 12, 2021 We think Keysight Technologies is the leader in communications testing and measurement solutions, and offers a vendor-agnostic way to invest in the rapidly growing 5G market. In our view, Keysight has the strongest and broadest communications testing capabilities in the market, inclusive of hardware, software, and services. We think a comprehensive portfolio allows Keysight to act as a strategic partner to its customers, enabling new designs and accelerating time to market for network operators, network equipment OEMs, device OEMs, and suppliers. We believe that Keysight can reduce time to market for customers more than competitors as a result of its end-to-end portfolio of premium offerings. We think Keysight’s leadership stems from its large investment in R&D--annually doubling that of the nearest competitor--that it focuses on the communications market. We also think hefty organic and inorganic investment has led to Keysight leading the market pivot toward software and credit its unmatched portfolio breadth for its top market share. We also contend that a broad portfolio that layers software and services on top of hardware embeds Keysight into customer workflows and entrenches customers in its ecosystem. A broad, sticky portfolio underpins our wide economic moat rating for the firm. Keysight should continue to dominate the communications market, especially as it pivots toward more complex 5G testing in which it is already demonstrating proficiency. We forecast market share gains for Keysight and think greater complexity in 5G networks will expand its wallet share at customers--both of which would result in continued outperformance of the underlying testing market. We expect the firm to continue shifting customers to subscription billing for its software and services and think it will complement continued organic investment with strategic M&A to further build out its software portfolio. We expect the growing mix of software and services to expand margins. Finally, we forecast Keysight to continue generating impressive cash flow and to send a large proportion of it back to shareholders. Economic Moat | by William Kerwin Updated Oct 12, 2021 In our view, Keysight Technologies possesses a wide economic moat owing to intangible assets in the design of test and measurement equipment and software and switching costs for its portfolio of solutions. We think Keysight is a leader in testing and measurement, helping OEMs and all tiers of suppliers accelerate time to market for new products in the communications, aerospace and defense, automotive, industrial, and semiconductor markets. We don’t expect any competitor to encroach on Keysight’s leadership--especially in communications--and expect the firm to earn economic profits over the next 20 years as a result of its comprehensive portfolio that layers software and services over hardware. Testing equipment is used by OEMs and suppliers during research and development and manufacturing to fine tune chips and devices to exact specifications. For example, Keysight manufactures millimeter wave transceivers and radio frequency (RF) emulators to test an RF chipset’s ability to transceive signals amid a variety of interference environments and signal strengths. Oscilloscopes can analyze the amplitude and frequency of a 5G signal in testing out a base station’s effectiveness. Similarly, Ethernet channel testing solutions enable suppliers to test the effectiveness of optical transceivers in data transfer and connectivity in a data center, connected car, or other application. We believe Keysight is the leading player in the communications testing market (which made up 74% of fiscal 2020 sales), in part from being the only player to service the entire communications ecosystem. Keysight’s portfolio addresses all layers of the communications stack, from the physical layer all the way through to the application software layer. We think having the most comprehensive communications testing portfolio in the marketplace makes Keysight a more efficient solution and gives it a leg up in acquiring new customers. Testing is an integral part of the development process, with engineers iterating designs in simulation software, testing different prototypes, and then implementing quality control in manufacturing. Each step introduces new variables to account for, and using multiple testing vendors across development can require calibrating equipment together and ensuring measurement differences aren’t resulting from different equipment. By using Keysight tools and software at each step, engineers can remove variability between each step, saving critical development time and accelerating time to market. Keysight takes this one step further with its PathWave platform, which aggregates software analysis from each step of the development process into one place, reducing variability and iterations and simplifying the process for engineers. In one case study, NTT Docomo credits using a comprehensive Keysight solution for shortening development time for its 5G deployment at the Tokyo Olympics by at least 20% and going to market a full year faster than the competition. With a portfolio addressing all facets of communications and including software, Keysight stands out among its testing peers as a strategic partner. Rather than selling into a specific portion of a customer’s development, Keysight can offer a complete strategy for reducing time to market that features its tools and software. We think unmatched portfolio breadth and leading capabilities have led to Keysight holding one of the top market shares overall in testing and measurement, a leading position in communications, and a dominant share of the 5G testing market. Management estimates that Keysight holds 25% of the overall testing and measurement market and estimates that 75% of 5G designs globally--between base stations and devices--have been developed using Keysight solutions. We posit that Keysight’s advantage in communications testing and measurement stems from hefty investment in research and development and vertically integrated production. Since spinning off from Agilent in 2014, Keysight has doubled its R&D expenditures, increasing R&D at a compound annual rate of 12%, compared with its top-line compound annual growth of 6% over the same period. While some of its peers invest similar proportions of sales into R&D, Keysight exceeds all of them in size, so its total R&D investment in a given year nearly doubles that of the nearest competitor. We think large R&D investment has allowed Keysight to invest aggressively in software and be first to market with a platform like PathWave. Moreover, Keysight gains efficiency from partial vertical integration, with about 50% of manufacturing taking place in-house. The firm operates its own fab in Santa Rosa, California, which it co-locates with its R&D staff. This allows the firm to quickly take designs into production and troubleshoot, rather than waiting on a foundry partner with myriad other customers to serve. We think this improves R&D efficiency and allows Keysight to sustain its high organic investment while staying profitable. Among its peer group, Keysight is the only one in the top three of both R&D as a percentage of sales and operating margin. In our view, the ability to invest twice as much as competitors while maintaining top-tier operating profits gives us confidence in Keysight’s ability to maintain its innovation lead over the next 20 years. We also think Keysight’s moat is bolstered by switching costs, stemming from an end-to-end solution set combining hardware, software, and services. Keysight’s solutions service the entire design cycle, from design and simulation all the way through to volume manufacturing and operation. We view Keysight as a one-stop-shop for customers and think this leads to switching costs as entire workflows get designed around Keysight’s solutions. Keysight’s comprehensive portfolio not only improves efficiency at customers but makes ripping its solutions out even harder--a customer would likely have to source from multiple suppliers if it chose to leave Keysight. For example, Keysight is the only testing player to supply electronic design automation (EDA) software for chips, which is typically a standalone market. Switching away from Keysight would likely require sourcing from multiple new testing suppliers and a new EDA supplier, too. We also think that Keysight’s focus on selling into research and development (roughly 60% of sales) versus manufacturing (roughly 30%) leads to stickier customer relationships. R&D relationships tend to be quite close--sales usually involve one engineer at a time. In our view, individual engineers exhibit stronger personal preference and stickiness than a company as a whole--once an engineer adopts Keysight into their workflow (and so long as it satisfies their needs), we think they’d be loath to learn an entirely new solution. Furthermore, selling early in development to R&D makes Keysight more likely to win manufacturing placements later in development. Manufacturing testing (quality control) is typically dual-sourced, but if a given supplier is used in R&D, it’s likely to be used predominantly in manufacturing, further reducing variability between measurements. A second testing supplier would then be used as a check, ending in roughly a 70%/30% split for Keysight and the competitor, respectively. We think Keysight entrenches customers even further by layering software on top of its solutions. It is our view that layering software on top of enterprise hardware creates an overall stickier combined solution that engrains itself deeper in customer workflows. Although all oscilloscopes, signal analyzers, and other testing hardware run on embedded software, Keysight has been pivoting to proprietary analytical software to optimize testing and measurement with its hardware. Keysight’s applications save engineers time by automatically analyzing massive quantities of data--an oscilloscope can make 256 billion measurements per second--and Keysight’s customers can aggregate all their data and subsequent analysis in its PathWave platform. Moreover, Keysight’s applications are modifiable. A Keysight application engineer will help customize a program to fit an engineer’s specific requirements at installation. We think an integral software approach with customization embeds Keysight’s tools into customer workflows and makes cobbling together a replacement difficult. Customers would have to replace more than physical tools, and adapt entire workflows to new software--or face the prospect of not finding similar functionality from a new vendor. Finally, we think the inclusion of services into customer contracts further augments Keysight’s stickiness. We think services both elongate the average duration of contracts and further embed customers in the Keysight ecosystem. Keysight has 68 regional services centers globally and locates them near hubs of customers. Keysight’s services vary in intensity. At a base level, Keysight customers utilize repair and calibration services annually or biannually--equipment needs to be calibrated for accurate measurements, similar to tuning a guitar or violin. Additionally, Keysight application engineers can work with customers to offer troubleshooting, usage guidance, and tweaking of software. For large customers, application engineers will even work on-site at a customer, integrating into the design team. In our view, services allow a customer to use their solutions for longer and create a stickier overall solution as software and workflows become customized to having Keysight as an on-demand partner. We think deep partnership and services has led to long customer relationships--sometimes lasting decades. We think Keysight’s sticky portfolio has led to a strong base of high-margin recurring revenue (over $1 billion annually) that we think will enable it to continue earning excess returns on invested capital. According to management, adding services to a contract can double the gross margin of a deal--and come at little additional cost to the firm. We credit growing software and services sales for helping to expand gross margins 5% in the six years since Keysight’s spin-off in 2014. Software and services now make up more than one third of Keysight’s top line, and we expect this number to expand. In 5G applications, which we expect to become a significant portion of sales, software alone can make up 40% of a contract. Additionally, over two thirds of Keysight’s engineers are now focused on software, and many of the firm’s recent acquisitions have been software-centric--exhibiting a companywide pivot toward software. In our view, strong recurring revenue gives us confidence in Keysight’s ability to retain customers in its ecosystem and in turn sustain economic profits over a 20-year horizon. Fair Value and Profit Drivers | by William Kerwin Updated Oct 12, 2021 Our fair value estimate for Keysight Technologies is $170 per share, which implies a fiscal 2021 adjusted price/earnings ratio of 28 times and a fiscal 2021 enterprise value-to-sales of 6 times. Following a sharp rebound from COVID-19 disruption in fiscal 2021, we anticipate 6.5% growth for Keysight through fiscal 2025. We anticipate the greatest growth out of the commercial communications market as Keysight acts as an integral partner to OEMs and suppliers for 5G network buildouts. We also think the firm will slowly take share in the budding automotive market and expect this to continue being the fastest grower out of its electronic industrial segment. We expect a mix tilting toward software and services to expand non-GAAP gross margins from 65% in fiscal 2020 up to 67% in fiscal 2025. We also think gross margins will see a boost from a greater mix of 5G networks, as these deals can feature up to 40% software content. We think expanding gross margins will boost operating profitability, which we think will further expand as the firm exerts operating leverage. We forecast R&D expenses to stay elevated but think the firm will benefit from scale on the SG&A line. All in, we predict non-GAAP operating margins to expand from 25% in fiscal 2020 to 32% in fiscal 2025. We project that Keysight can capture an incremental operating margin of 45% on new revenue, slightly better than management’s long-term goal of 40% that we view as conservative. Risk and Uncertainty | by William Kerwin Updated Oct 12, 2021 We assign Keysight Technologies a high uncertainty rating. The firm is heavily exposed to the communications market, making up 74% of fiscal 2020 sales, and we think any downturn or slowdown in this market would have an outsized effect on Keysight’s results. Additionally, much of our forecast for the firm’s top-line growth and profitability rests upon 5G network buildouts, and slower-than-expected adoption could hamper Keysight’s growth and profitability. We also think Keysight faces risk from its mix shift toward software. We view Keysight as the leader among its peers in the transition but think the pivot offers an opportunity for a competitor to disrupt the market. If Keysight fails to maintain its leadership in software, its competitive position could weaken. In our view, Keysight’s active M&A strategy poses another risk. We forecast a steady stream of tuck-in acquisitions for the company helping to pad growth and profitability. If the firm fails to make the right deals, or overpays for targets, it could hamper growth and destroy value. If Keysight’s inorganic strategy slows altogether, it could risk losing key additions to competitors and its competitive advantage could grow slimmer. Finally, we foresee minimal environmental, social, and governance (ESG) risk for Keysight. The firm’s greatest material ESG issue (MEI) in our view is the risk of losing human capital to competitors, but we don’t see evidence of this happening and think a strong variable compensation program helps keep talent motivated to remain at the firm. Capital Allocation | by William Kerwin Updated Oct 12, 2021 We rate Keysight Technologies’ capital allocation as standard, based on our assessment of a sound balance sheet, fair investments, and appropriate shareholder distributions. Keysight’s stated capital allocation priorities, in order, are organic investment, strategic M&A, and share repurchases. We think Keysight’s balance sheet is in sound position, with a net cash position and long-dated debt maturities. We also think Keysight’s investment strategy is fair. We approve of the firm’s focus on organic investment, specifically in R&D, which we think has allowed it to carve out a wide economic moat. We also think that Keysight’s M&A strategy has given it access into high-growth future markets like quantum, and has helped it to transition to a more integrated software approach. Finally, we think Keysight’s shareholder distributions are appropriate. The firm targets sending 50% of its free cash flow back to shareholders in the form of repurchases, though it hasn’t hit that target in any year since its 2014 spin-off. Nevertheless, we think its repurchases have been consistent and sizable and forecast it to come closer to this target as free cash flow grows. We also credit the firm for focusing on investment first, while using its heady free cash flow to send leftover cash to shareholders. |
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