Keysight Is Positioned To Profit From Secular Growth Markets

Shares of Keysight Technologies, Inc. (NYSE:KEYS) have held up relatively well during a period that has been brutal to many technology companies. With its movement toward software from hardware, it has handled supply chain issues well, and it is a secular beneficiary of 5G, defense modernization, and electric and autonomous vehicles. Given it is not focused in AI, it also has less exposure to U.S.-China trade restrictions, though that does remain a risk. At a bit under 20x earnings, KEYS is an attractive “growth at a reasonable price” (GARP) stock.

In the company’s fiscal third quarter, results were ambiguously strong. Revenue rose 10% (13% organically) to $1.38 billion. Orders rose even faster at 12% (14% organic) to $1.46 billion. So far this year, the company has received about $500 million more in orders than it has booked in revenue for a 1.1 book-to-bill ratio, which is creating the pipeline for further growth. Given it has trouble meeting the demand it has, pricing power is solid. Gross margins are a robust 65%, and operating margins rose 290bp to 30.1%. This translated to EPS growth of 31%, above the high end of guidance, at $2.01. It was also impressive during a quarter where so many companies complained of foreign currency swings that while FX has been a top-line drag, its hedging program has insulated the bottom line.

The Communications Solution Group ((CSG)) is its primary unit, accounting for over 2/3 of Keysight’s revenue. Commercial communications (70% of this unit or half of the company) had a record quarter both in terms of revenue and orders. Its aerospace, defense and government sub-unit saw record orders. The commercial business is benefitting from the rollout of 5G, while its AD&G unit is seeing wins from cyber and satellite applications. Its biggest challenge is working through supply issues to meet the demand

Within this unit, management continues to focus on expanding software offerings to monitor networks to build more recurring revenue. Keysight’s solutions help to manage frequency band combinations, manage power consumption, and validate performance across networks. As wireless companies roll-out large cap-ex plans to implement 5G everywhere, there is natural demand for Keysight’s validation and operational equipment and software.

At the same time, U.S. defense spending is set to rise meaningfully this year. While the Pentagon has asked for a $31 billion increase in its budge to about $773 billion, the House and Senate are negotiating between $840 and $857 billion for the upcoming National Defense Authorization bill. With a bipartisan push to combat Russia and China, there will be more defense spending in years to come. Within that, modernizing communications networks as well as developing space and satellite communication systems are clear priorities (not just in government but also increasingly in the private sector). These tailwinds should support ongoing revenue growth for Keysight.

Its other unit, Electronic Industrial Solutions Group (EISG), accounts for just under 1/3 of Keysight’s revenue. It, too, saw record orders and revenue with particular strength from the auto and energy sectors. It has equipment and software tools for both electric and autonomous vehicles. The company has also benefitted from the fact its own semiconductor capacity has improved. Its auto business has nearly doubled over the past two years, with a focus on vehicle communication and radar systems that help test real-world autonomous vehicle technology in a lab.

The roll-out of autonomous vehicles is likely to take years further in R&D work, and Keysight will be there providing the underlying analytic support for that research. At the same time, it has leading sensor technology that test and monitor how electric vehicles and battery performance work outside of the factory and in the real world. While its EV business is “here and now,” its AV offering provide multiple years of growth potential.

These strong results are being delivered across the world as Keysight is a very global company. The Americas account for 41% of revenue, Asia, 44%, and Europe 15%. Europe was the laggard with sales just up 3%, though there was a 7% currency headwind. Asia saw the fastest growth with a 15% organic sales increase thanks to strong partnerships with Singapore tech firms. As of 2021, China accounted for less than 19% of Keysight’s revenue. The majority of its Asia business is outside of China.

This is important to highlight, because just about every technology company has some China exposure, and with trade relations seeming to be in structural decline, this is an important risk factor when considering tech stocks to invest in. Recognizing this, in its quarterly filing, it mentions risk around U.S. and China relations ten times. In fact, last year, Keysight paid a $6.6 million fine over violating export restrictions. Past restrictions on network and defense equipment under the Trump Administration already have impacted Keysight and are “in the numbers” that the company is reporting now, rather than representing downside risk from here. With tensions being focused more on semiconductor manufacturing equipment and AI chips, incremental policy risk appears to be less of a prospective headwind for KEYS than other tech firms.

A full-blown rupture of U.S.-China trade will have unknowable consequences, across many sectors. But given the majority of Keysight’s revenue in Asia comes from outside of China and that its China exposure fell over the past three years, I see the company as being less immediately exposed to these tensions than many other tech companies.

Alongside these strong Q3 results, Keysight raised full year revenue guidance to about 9% or $5.375 billon with EPS now expected to be up 19-20% or $7.43-7.49 from 14-15% previously. This implies $1.94-$2.00 in Q4, and considering strong operating performance all year, I would expect results to be at the high-end of guidance when reported, likely in mid-November. Importantly, as the company prepares its new three-year plan for discussion alongside the fall results, it sees upside relative to its original hopes for 2023, according to comments made during the last earnings call. With a strong backlog and secular tailwinds, we are likely to see another year with about 10% growth.

KEYS is delivering this while having a very strong balance sheet. It carries $1.8 billion of cash and zero net debt. It is investing heavily in the future; R&D is 15% of revenue. This should ensure it continues to have the leading technology offerings for years to come. Still, free cash flow year to date has been $556 million despite a $410 million working capital drag, for a $1.2 billion normalized annual pace. This has enabled $723 million of buybacks year to date.

Keysight is an important provider of software and equipment that make 5G and satellite networks operate and that test the efficacy of AV and EV auto solutions. These strong end-markets lay the groundwork for continued strong earnings growth, free cash flow generation, and buybacks. With 10% EPS growth, KEYS can earn $8.20-$8.40 next year and has a forward free cash flow yield of 5%. Given its sustained double-digit growth prospects, its share are an attractive GARP opportunity at 19x forward earnings. I can see shares returning to the $175 area or a bit over 20x forward earnings. With its integral role in technologies of the future, KEYS is a compelling long-term investment. I would recommend building positions here and using weakness to add.