Keysight Technologies Offers Enough Quality Growth To Support A Robust Valuation (KEYS)

There are plenty of sayings (and cliches) regarding valuation and quality in the investment world, but it is nevertheless true that quality, value, and price are all distinct characteristics. I mention this because I think it’s an important backdrop for looking at Keysight Technologies (NYSE:KEYS). This leader in electronic design and test and measurement tools isn’t conventionally cheap, but I do think the less-cyclical nature of the business, the quality of the business, and the longer-term growth and margin potential combine to make a stronger value call than the multiples might otherwise suggest.

I’m not saying that Keysight is cheap, but I do think investors can expect to get solid value for the money here. I do see some risk that macro headwinds could prove stronger than the Street expects in calendar 2023, but I like the company’s long-term leverage to macro trends like data traffic growth, connectivity, and electrification. At $165 or below this would feel like an easier (or safer) call, but even at today’s price I think long-term investors can reasonably expect to be happy with the long-term returns.

Macro Challenges Are Growing

Whether the U.S. will see a recession in 2023 is still up for debate, but there seems to be little argument that business activity is slowing. Several high-quality industrials warned of weakening trends and a likely recession back with third quarter reports, and I expect to hear more of the same this quarter.

How this will impact Keysight is nuanced.

For starters, about 60% of the company’s revenue is tied to R&D projects, and most companies are loath to meaningfully cut R&D, particularly heading into what should be a relatively mild economic downcycle. Moreover, companies continue to invest resources to prepare for future evolution in wireless (6G), wired (800G/1.6TB), connectivity (IoT and other drivers), and electrification (autos). This should provide a meaningful ongoing base of business that will drive less cyclicality in Keysight’s reported results.

Another 10% or so of Keysight’s business is tied to post-deployment, installation, and maintenance functions. While I would think installation activities could slow, I wouldn’t expect meaningful declines in post-deployment or maintenance activities, particularly given that a lot of these tasks had to be delayed during the pandemic and supply shortages since then have made the catch-up process more challenging.

That leaves around 30% of the business that is tied more directly to current/near-term manufacturing. A significant portion of this is tied to 5G, and while deployments are expected to slow in 2023, I would note that a lot of deployments were deferred into 2022 due to supply/component shortages in 2022. Wired networking is also a meaningful portion, and I expect good demand for 400G/800G deployments. I also expect a healthy auto market (around 5% of total revenue), with ongoing growth in EV production, as well as ongoing growth in aero/defense.

Around 10% to 15% of the business is tied to various electronics, including smartphones, and I definitely expect more weakness here. Likewise, IoT chip and device production is likely to slow considerably as inventories get worked down across end-markets like metering and home networking. I do see some possible risks in the outlook for the semiconductor space as well, but I believe Keysight’s business is more skewed to leading-edge nodes where I expect much less pressure on volumes (particularly with still-strong demand for high-end networking, AI/machine learning, and so on).

Long-Term Opportunities To Grow And Improve The Business

Since spinning out from Agilent (A) in 2014, Keysight has established a strong growth track record, with over 7% compound annual growth in revenue and free cash flow, as well as steady improvement in margins. I see drivers in place to continue a good track record of growth and margin leverage.

One of the more significant drivers I see is an ongoing effort to grow the software business. Software makes up somewhere in the neighborhood of 20% of revenue today, and the company saw good growth in software ARR in the recently-completed fiscal year. Around one-quarter of the software business is in standalone products for testing, emulation, digital twinning, and similar tasks, and I think outsized investments in R&D and personnel (software engineers) will produce growth here, as well as in standards-driven software and tool-related software.

As software revenue grows toward 30% and possibly beyond, I could see two points or more of gross margin expansion and likely even more expansion in operating margins. I believe expanding the software side also has competitive advantages – NI (NATI) (formerly “National Instruments”) has strong simulation and validation software capabilities, and I think this has helped the company take an initial lead in some markets (like EV/battery development).

I also see opportunities for Keysight to continue to grow on the back of strong secular market drivers. At the risk of oversimplification, I see no slowdown in data traffic growth, nor the growth in semiconductor complexity, electrification (buildings, factories, autos, and so on), and connectivity (from home appliances to electronics to autos and industrial machinery). As companies work to develop these products, they will turn to Keysight for critical tools needed in the R&D, manufacturing scale-up, manufacturing, and maintenance processes.

Keysight has benefited significantly from the 5G cycle, and while I believe this business could peak in a year or so, certain “sub-categories” like mmWave and O-RAN still have a lot of room for growth. Moreover, investments in 6G are beginning. Likewise in wired networking; 800G is still in its early days in terms of real-world adoption, but I expect significant growth over the next few years, while initial development work on 1.6TB has already begun.

Autos and aerospace are likewise notable growth opportunities. About two-thirds of this business is R&D-driven today (EV drivetrains, battery management, ADAS, connectivity), but the production side will pick up as more EV models launch, and I think the company is particularly well-placed to benefit from its capabilities in high-power semiconductors (design/testing, etc.) and wireless communications. With aerospace, I expand a defense upgrade cycle (including connectivity) and I see good leverage to growth in commercial space.

The Outlook

I expect the main driver of margin leverage from here to be the company’s ability to grow its software business. The main business is designed such that there’s not as much margin deleverage when revenue weakens, but also not as much margin leverage when revenue accelerates. That less-cyclical mix is arguably attractive at this point in the cycle.

I expect long-term revenue growth in the neighborhood of 6%, though I also expect the next two years to be a bit below that level. I think margin leverage will likely be a little more challenging over the next two years as well, but I expect EBITDA margins to stay above 30% and move towards the mid-30%’s over the next five or so years. At the cash flow level, I expect free cash flow margins to grow slowly from the low-20%’s toward the mid-20%’s (in five years) and possibly into the high-20%’s over a decade-plus time horizon. That would drive around 10% annualized free cash flow growth ; management likes to reinvest in the business (R&D, capex, and M&A), but has been getting more active with share buybacks. As cash flow grows, I expect an ongoing interest in M&A, but also more returns of capital to shareholders.

Discounting those cash flows back, I think Keysight is likely priced for a long-term annualized total return in the neighborhood of 8%. That’s not bad, but it’s also not exceptional – this is a case where I think quality comes into the picture (accepting a modestly lower return in exchange for greater certainty about the return). Likewise with my margin/return-driven EV/EBITDA approach. I’m willing to give Keysight a “compounder” premium, but even with a 20x forward EBITDA multiple (versus the 17x or so that the company’s attributes would otherwise merit), I only get to a fair value in the $190’s.

The Bottom Line

I see no reason to expect Keysight to be trading cheaply; management has continued to execute well, the company is leveraged to several attractive long-term secular growth trends, and the near-term economic risk seems moderate. Still, market sentiment can be volatile and there is some risk here that numbers will have to come down on greater customer headwinds. I do think the valuation today is good enough to consider, but were the shares to sell off in the $160’s, I think it would be a pretty compelling buy.