Methode Electronics: 60% Upside After Overdone Sell-Off

Summary

MEI trades at only 6x LTM EBITDA after just posting a record year for revenues and profitability.

In the past 3 years, the company has achieved revenue and EBITDA CAGRs of 24% and 75%, respectively.

While the long-term growth story remains intact, MEI is now trading at a 40% discount to its 3-month high because of a weak FY 2016 guidance.

We expect the company to rebound in FY 2017 with another record year as several promising contracts are slated to commence.

With its strong backlog, exciting product pipeline, and the potential for share repurchases or a buyout, we believe MEI offers compelling asymmetric upside at current prices.

Methode Electronics (NYSE:MEI) manufactures highly-engineered electronic component devices for original equipment manufacturers (OEMs) in various industries. Within its largest segment, Automotive, MEI's products include the integrated center stack (center console screen), transmission frames, sensors, and various ergonomic and hidden switches. Within the Interface segment, products include solid-state touch interfaces for consumer appliances (washers, dryers, ovens), radio remote control systems for industrial applications (concrete pumps, cranes, locomotives, work platforms, etc.), as well as transceivers, fiber optic and copper cable assemblies for data centers. Finally, through its Power segment, MEI produces electric vehicle bus bar assemblies (Nissan Leaf and Tesla S) and power rail products for big data customers.

(click to enlarge)Source: SEC filings

(click to enlarge)Source: SEC filings

Company Background

Headquartered in Chicago, Methode was founded in the 1940s and primarily provided circuit boards to television and other consumer electronics manufacturers in its early years. In the 1970s, the company began to expand into the automotive and aerospace markets, but most of its products were highly commoditized. In 2007, the management team started executing a plan to transform MEI from a component vendor of undifferentiated, commodity-like products into a company that offers innovative, patented, and highly-engineered product solutions with world-class manufacturing expertise. In the late 2000s, Methode was awarded a significant contract to provide the center stacks for several Ford/Lincoln models (Edge, Explorer, Flex, Taurus, MKS, MKT, MKX). In 2010, the company announced another massive victory - it had won an even bigger contract to provide the center stacks for multiple GM/Chevy models (Tahoe, Yukon, Silverado, Sierra, Suburban, Canyon, Colorado). As MEI successfully shifted its focus toward higher value-add products, its financial performance reached new highs:

(click to enlarge)Source: SEC filings

Today, Methode is truly a global player with manufacturing, design and testing facilities in China, Egypt, Germany, India, Italy, Lebanon, Malta, Mexico, Singapore, Switzerland, the U.K. and the U.S. Through its transformation, the company has built an impressive roster of clients:

(click to enlarge)Source: SEC filings, MEI press releases, earnings calls, and investor presentations

Poised to Benefit from the Secular Shift toward Smarter Cars

It's no secret that more electronic components and modern technologies are being applied in the automotive industry. As the capabilities of our smartphones have increased exponentially, consumers are demanding better user interfaces and functionality in our automobiles. As a result, OEMs have been investing more in the center stacks of new cars. This trend is expected to continue for at least the next decade.

• Based on our research, 10 years ago, electronic components comprised ~25% of the parts value in the average car. Today, it's estimated that electronic components make up approximately 40%.
• Last year, roughly a quarter of new cars shipped had some kind of infotainment system in the center console. Industry experts estimate that in 10 years, the majority of new cars will have an infotainment screen.
• According to IMS Research, 5.8 million automotive touchscreens were sold globally in 2011; they predict that sales volume will rise six-fold to 35.7 million in 2019.

Methode is well-positioned to capitalize on this massive secular trend. We estimate that center stack sales accounted for 35-40% of the company's revenue in FY 2015. MEI is considered one of the top Tier 1 suppliers to the OEM marketplace due to its innovative product lines, global manufacturing capabilities, reliability, and its seasoned launch and design teams. Across GM/Chevy and Ford/Lincoln, Methode has successfully launched and executed center stack programs for 15 different car models (sedans, trucks, and SUVs).

While there are several competitors in the center stack space, our research indicates that MEI possesses a strong reputation within the industry for its quality and reliability.

• MEI has the best technological solution for minimizing heat. Since the OEMs are intensely focused on reliability, and heat is the enemy of all electronics, we believe this is a strong competitive advantage.
• Methode ranks amongst the best when it comes to energy efficiency.
• MEI's center stacks have better touch sensitivity than most of its competitors.
• Since MEI has far fewer automotive product lines compared to competitors like Alpine or Delphi, its engineering resources are more focused. As a result, Methode's engineering talent is highly-regarded due to their specialization. Rather than being a jack of all trades, master of none, MEI is really good at designing and manufacturing a few auto products (center stack, transmission frames, switches, and sensors).

Why Does the Opportunity Exist?

(click to enlarge)Source: Bloomberg

MEI's stock price fell off a cliff after reporting its FY2015 earnings at the end of June. While disappointing, the Q4 results were actually not terrible. What really spooked investors was the guidance for FY 2016:

• Revenue of $830 million to $865 million
• Operating income of $108 million to $119 million
• EPS of $2.07 to $2.22

While management's guidance was lower than our expectations, it wasn't much lower. For investors who had been following the company closely, it was no surprise that FY 2016 would be a down year given the visibility into the contracted backlog. We already knew that the Ford center console program would be rolling off this year, which would be a ~$30 million hit to annual revenues. We also knew that the sale of Trace Laboratories in February would reduce sales by another ~$5 million. We fully expected that FY 2016 would be a down year for MEI after growing its topline by an average of 24% over the last 3 years.

There were really only two elements of the guidance that did surprise us:

1. In its Interface appliance business which represents ~8% of sales, management expects that more of its appliance customers would migrate away from Methode toward an in-house design and contract manufacturing model to reduce costs. As a result, the Company recorded an $11mm goodwill impairment charge. While this is certainly a negative development, Interface solutions for appliance customers make up a relatively small piece of the total business, and management has declared that they will refocus their Interface business on medical and vending food service end markets where margins are higher.
2. Power rail sales are expected to decline $20mm in FY 2016. This is largely a capex timing issue, as power rail sales in FY 2015 were $20mm higher than management had anticipated. A big data customer accelerated the buildout of its data centers, which boosted 2015 numbers, but will cause a dip this year. We don't believe this development fundamentally changes the long-term prospects for the Power Products business.

Although management's guidance was underwhelming to say the least, it wasn't that bad! We certainly don't believe it warranted a 40% sell-off. The two developments that surprised us are relatively minor in the grand scheme of things. Neither issue had any impact on MEI's Automotive segment, which is where the long-term growth story resides. We believe the steep sell-off was the result of growth and momentum investors blowing out of their positions after hearing management guide to a down year (which would be the first in six years). With the stock meaningfully de-risked for the rest of the year, we view this as an attractive opportunity for long-term value investors to accumulate shares at a large discount to historical multiples despite the fact that the long-term thesis hasn't materially changed.

(click to enlarge)Source: Capital IQ

Despite all indications that FY 2016 will be soft, we're still projecting MEI to deliver a ~9% free cash flow yield for shareholders this year. Additionally, management stated that they are targeting a 5-year EBITDA CAGR of 9-10% on the earnings call. Clearly, the market isn't giving much credence to these claims, but we should point out that management has historically been conservative with their guides:

(click to enlarge)Source: Bloomberg

(click to enlarge)Source: Bloomberg

Big Rebound Coming in FY 2017

We believe investors will be handsomely rewarded for being patient with the stock, as the future looks bright in FY 2017 and beyond. After a hiccup this year, we fully expect MEI to rebound in FY 2017 with another year of record revenue and EBITDA. Methode has several promising contracts on the horizon that will return the company to healthy growth. Here are some of the significant awards expected to commence or ramp significantly in FY 2017 and FY 2018:

• Two additional center console programs with GM beginning in late 2016 with expected annual revenue of $30 million. One of the programs is for South America which would be MEI's first in that continent.
• One center console program for Renault commencing in late FY 2016, ramping up to an estimated $11 million of revenue in FY 2017. This is another important milestone for the company as it represents Methode's first high-volume launch in Europe.
• Center console program for an unnamed domestic OEM launching in FY 2018 with expected annual revenue of $18 million. This program is for an SUV.
• Entertainment module for Fiat-Alpha launching in FY 2018 with expected annual revenue of $6 million. This launch will be for Europe, Asia, Japan, and the Middle East.
• Infotainment and HVAC modules for the next line-up of Aston Martin vehicles beginning in FY 2017 with expected annual revenue of $4 million.
• Center console program for Subaru Impreza commencing in FY 2017 with expected annual revenue of $6 million for MEI. Harman will be providing the infotainment content, while Methode will be manufacturing the Class A center console module.
• Multimedia system for Fiat Chrysler beginning in FY 2017 with expected annual revenue of $4 million.
• HyperTouch sensor program for the Honda Odyssey beginning in FY 2017 with expected annual revenue of $5 million.
• Lithium ion uninterruptable power supply commencing in FY 2016, ramping up to an estimated $18 million of sales in FY 2017.
• 10G copper transceivers launching in FY 2017 with estimated annual revenue of $18 million.
• Torque sensor sub-assembly for electric bikes ramping in FY 2017 with estimated annual revenue of $10 million.
• Hidden and tailgate switch products for Ford and McLaren beginning in FY 2018 with expected annual revenue of $8 million.

The average life of these programs is 4-5 years, and they will more than make up for the contracts rolling off in 2016. The awards from Nissan-Renault, Fiat-Chrysler, Aston Martin, and Subaru also represent Methode's first center stack programs outside of GM and Ford. They are a nice foothold for MEI to demonstrate its value, putting the company in an excellent position to win additional awards. We are particularly excited about the Nissan-Renault and Fiat-Chrysler contracts as they only represent a small sliver of each OEM's global volumes.

Projections/Valuation:

Our base case projections assume no share repurchases or acquisitions:

Source: Proprietary

Based on these projections and assuming an 8.0x multiple for FY 2018E EBITDA, we arrive at a 2-year price target of $44, representing more than 60% upside:

Source: Proprietary

The 8x forward EBITDA multiple is predicated on keeping the GM K2 center stack contracts when they come up for rebid. We should also note that management has guided to an effective tax rate of only 25%, which we believe warrants a marginally higher multiple than it otherwise would deserve.

(click to enlarge)Source: Capital IQ

Risks

1. Without question, the most significant risk to our thesis is if Methode fails to keep the K2 center stack contracts with GM. The K2 program was awarded to MEI in 2010. The 6-year program covers the center stacks for the Silverado, Sierra, Suburban, Tahoe, Yukon, and Yukon XL (model years 2014-2019). These contracts account for ~$180 million of annual revenues. Although these contracts won't expire for another 3-4 years, it is expected that GM will conduct a bidding process in the next 12 months for model years 2020 and beyond.

We think it's unlikely that MEI will lose the contracts. An OEM executive we consulted estimates that incumbents win center stack awards 80% of the time. Methode has a cost advantage versus other competitors, because GM has already invested in tooling and configurations specific to MEI for the current program. Furthermore, Methode and GM's engineers possess strong relationships, having worked closely together for the last 5 years. From what we have heard, MEI has done an outstanding job launching and executing the K2 program. The fact that MEI is launching two additional center stack programs for GM in late 2016 is a promising sign.

In the unlikely scenario that MEI fails to keep the K2 contracts, there would be no material impact to our base case revenue and cash flow projections through FY 2018 as the current programs won't go end of life until model year 2019. However, it would certainly impair the valuation multiple.

2. Methode faces high customer concentration. For FY 2015, shipments to GM and Ford, or their tiered suppliers, represented 44.8% and 12.8%, respectively, of total sales.

This is the reality of being a manufacturer for automotive OEMs. The customer concentration risk is a big reason why we don't ascribe a higher valuation multiple for the business. However, with MEI recently adding new customers such as Nissan-Renault, Fiat Chrysler, and Honda, we are optimistic that the company will continue to diversify its customer base.

3. There is a bear thesis in the market regarding imbedded infotainment systems. Some analysts believe that the advent of Google's (NASDAQ:GOOG) Android Auto or Apple's (NASDAQ:AAPL) CarPlay will destroy the value proposition for players with high software content like Harman (NYSE:HAR).

Whether this premise plays out or not, we don't think Methode is at risk, because MEI is a hardware manufacturer. Even if a car uses Android Auto or Apple CarPlay for software, it will still require a physical touchscreen. In fact, Methode is already working on a center stack solution that would utilize a driver's smartphone as a media server and duplicate phone functionality through the vehicle touchscreen. Methode's dollar content per vehicle is less than $40. Compare that to Harman, which has a large software component and a dollar content per vehicle estimated to be $800-$1,000. If anything, we think the development of Android Auto and Apple CarPlay will benefit MEI long-term, as it should increase the number of vehicles with touchscreens.

Scenarios that could Provide Upside to our Base Case:

Using the Cash on the Balance Sheet

The Company has over $160 million of net cash on the balance sheet, which equates to ~$4.25/share. Management mentioned the possibility of a share repurchase in the last earnings call. Given where the stock is currently trading, a stock buyback would be massively accretive to EPS even if the company paid a large repatriation tax (96% of cash is parked overseas).

Let's assume management repatriates $150 million of cash on hand to fund a share repurchase, and after paying taxes, the net proceeds come out to $100 million. At the current share price, this would enable the company to buy back ~3.7 million shares (almost 10% of the outstanding share count). After taking our base case financials and accounting for the foregone interest income, we arrive at an FY 2017E EPS of $2.80 (~8% higher than our base case).

If we were managing the company, we would take on debt and fund an even larger share repurchase. Considering Methode's attractive earnings yield and the current cost of corporate debt, the existing capital structure is suboptimal. Using leverage to fund a buyback would reduce the company's weighted average cost of capital and be significantly accretive to EPS, ultimately driving better returns for shareholders.

If Dabir Becomes a Real Business

(click to enlarge)Source: MEI Investor Presentation

Dabir Surfaces is a new product being launched by MEI to prevent pressure ulcers. Nearly $2 billion of annual cost is attributed to hospital-acquired pressure ulcers which are no longer covered by Medicaid and Medicare. Management believes Dabir can be applied for long-duration surgical procedures as well as for patients in recovery or long-term care settings such as nursing homes. Management's commentary from the last earnings call:

"Moving to an update on the Dabir Therapeutic Surfaces. As of last week, 341 cardiovascular operations and other surgical procedures have been performed, ranging from 4 hours to 20 hours in duration. Additionally at our beta site, we have expanded into other operating rooms as well, surgical recovery areas or what is referred to as Med-Surg in the ICU. Additional surgical and Med-Surg ICU product evaluations are also in progress at two other sites, with clinical success being reported. Additionally, several other hospitals throughout the country have expressed interest in both product evaluation and potential commercial implementation.

Channel to market development continues, with sales coverage now in 15 states, predominantly east of the Mississippi, but also in Texas. The Dabir team continues its representative training and national recruiting. Finally, we are investigating the requirement for international sales expansion, as we anticipate meeting the requirements in this fiscal year for CE marking in Europe, which is similar to Underwriters Laboratory in the US. We continue to generate a great deal of interest from the medical community with this product, and at this point, feel adoption of this technology as a standard-of-care could become a reality."

Currently, the sell-side does not have any Dabir revenues embedded in their estimates. While we are still in the early innings of the commercialization of this product, if Dabir materializes into a real business, this would provide further upside to MEI's implicit value. We view Dabir as essentially a free call option.

Buyout by a Sponsor or Strategic

We believe there's a decent chance that MEI gets acquired, particularly if the stock price remains at these depressed levels. If you believe management's 5-year target for a 9-10% EBITDA CAGR, given the company's attractive free cash flow yield and under-levered balance sheet, we believe a financial sponsor could pay $40/share in an LBO transaction and generate a 20% IRR.

With the benefit of synergies, a strategic could pay even more. According to E&Y, "anticipation of transactions has never been higher in the automotive sector." Just in the last couple months, two competitors announced acquisitions with large multiples for targets comparable in size to MEI:

• In June, Amphenol (NYSE:APH) announced the acquisition of FCI Asia for $1.275 billion (10.6x 2015E EBITDA)
• In July, Delphi (NYSE:DLPH) announced the acquisition of HellermannTyton for £1.034 billion (14.3x LTM EBITDA)

With MEI's industry-leading earnings yield, an acquisition of Methode by any strategic would likely be accretive. The real possibility of a takeout is another reason we believe MEI offers asymmetric upside.

Summary

We believe the market dramatically overreacted to the company's latest earnings report. The negative surprises that spooked investors did not involve MEI's Automotive segment, which is where the long-term growth story resides. With shares are trading at a 40% discount to its 3-month high, the stock is meaningfully de-risked for the next year. Methode is well-positioned to capitalize on the center stack revolution. Our 2-year price target is $44. There are also realistic catalysts (share repurchase, Dabir, M&A) that could provide meaningful upside to our base case. We believe MEI offers an incredibly compelling risk-reward profile for long-term investors.

By Andrew Tang

Source: http://seekingalpha.com/article/3439756-methode-electronics-60-percent-upside-after-overdone-sell-off