Headquartered in Santa Rosa, CA, Keysight Technologies is a leading electronic test and measurement company. The company’s history dates back to 1939 as the original business of Hewlett Packard. Its first instrument, an audio oscillator, was used to test sound equipment for Disney Studios. Over time, Hewlett Packard moved into computing technology and this legacy business was spun off multiple times. As a standalone business today, Keysight’s products are used by communications and electronics engineers to measure electronic signals, helping them develop and manufacture cutting edge technologies faster and at a lower cost.
Fueling Its Own Fire
For most of its history, Keysight was constrained by its role as the cash cow for other businesses. In the 1960s, its cash flows helped Hewlett Packard blaze the trail into enterprise and personal computing. Later as a part of Agilent Technologies, it funded the expansion into life sciences-related opportunities. Now, Keysight can for the first time devote all of its resources towards accelerating its own growth. Since the spin-off in 2014, the company has improved organizational efficiency, increased investment in research and development and strengthened its product portfolio. This is no longer the business founded nearly 80 years ago in a one-car garage in Palo Alto. Today’s Keysight is targeting mid-single digit revenue growth, low-twenties operating margins and double-digit earnings per share growth.
Ready For 5G, and Beyond
With over 60% of the business tied to the communications industry, Keysight’s positioning for 5G wireless technology is the key focus of investors today. The company has been leveraging its long history and deeply rooted relationships to gain a seat at the table as standards are being set, giving it an early advantage as 5G is tested and deployed in the coming years. Last year, it was first to market with several design solutions, generating over $100M in orders. Yet, that is only part of the story. We see several other underappreciated tailwinds to fuel growth, including artificial intelligence, Internet of Things, autonomous vehicles, virtual reality and even advancements in electronic warfare.
Counting The Cash
Now that over three years have passed since the spin-off, Keysight has started to return its attractive free cash flows to shareholders. Until recently, the focus had been on increasing internal investment in research and development and acquiring companies to help accelerate the growth profile of the business. With that phase complete, capital allocation has shifted to paying down debt and buying back shares. By the end of this fiscal year, Keysight expects free cash flow conversion to be over 80%, gross leverage to be just 2.0x and the bulk of free cash flow to be directed towards a new $350 million share repurchase program.
A Long Term View
At current levels, investors remain both anchored in the historical growth profile of the old Keysight, while also impatient for the tailwinds from future technologies. As long term investors, we see a rare example of an excellent, competitively advantaged franchise that stands to benefit from several nascent technological mega trends. Since our initial purchase nearly a year and half ago, Keysight has consistently exceeded investors’ expectations, another trend that we believe is still only in the early innings. As of March 29, 2018, shares traded at $52.39, a 10.5% discount to our private market value of $58.52.
Founded in 1878, Mohawk Industries is the world’s leading manufacturer and distributor of floorcovering products. The company markets to both residential and commercial customers competing in all major flooring categories including carpet, hardwood, laminate, vinyl and ceramic tile. Some of the most recognizable brands include names such as Mohawk, Pergo, Karastan, Daltile, Quick-Step, and American Olean.
Covering the World One Step at a Time
When we initiated our position in Mohawk, the company was the leading manufacturer of carpet in the United States. Through several acquisitions, floorcovering product portfolio growth, and geographic market expansion, the company has become the world’s leading manufacturer of floorcovering. Mohawk now serves over 25,000 customers in 170 countries with manufacturing facilities in 17 countries. With significant insider ownership by a tenured, superior management team, Mohawk has blossomed into a large, highly-respected organization within the building supply sector.
Industry Continues to Rebound
Following the Great Recession, the U.S. floorcovering industry declined a devastating 38%. After hitting bottom in the U.S. in 2011, the industry is now in the seventh year of a rebound. Despite this recovery, floorcovering still remains 12% off its 2005 peak. In our view, the industry’s growth can be propelled by a number of tailwinds: continuing economic expansion as unemployment and mortgage rates remain low; solid GDP growth; and a growing number of first time home buyers. Historically, these forces drive new home construction and home sales, thereby, driving floorcovering growth. In addition to residential growth opportunities, the commercial marketplace accounts for 26% of the U.S. floorcovering market. Historically, as companies find it difficult to attract and retain employees in low unemployment environments, managements use upgraded office space as an attractive option. Businesses are sitting on substantial amounts of cash fueled by worldwide economic growth and tax reform within the United States, which should allow for continued office upgrades. We think the combined effect of these positive factors should translate into continued solid revenue growth for Mohawk.
Short-Term Pain for Long-Term Gain
Unfortunately, during the first-quarter 2018 Mohawk’s shares underperformed for several reasons. First, concerns over inflation and raw material price increases grew. Historically, the industry has raised prices to offset increased costs. Second, the company surprised Wall Street when it announced a heavy internal expenditure year for 2018. Mohawk will be investing to meet the increased demand in sales capacity growth. Over the years, this management team has proven to be smart capital allocators. They have remained disciplined in a fast consolidating industry and stayed focused on paying down debt. As a result, Mohawk boasts a strong balance sheet that is well positioned for long-term growth. We believe raw material costs and targeted investments may cause some short-term pain but will ultimately lead to higher long-term profitability.
As of March 29, 2018, shares traded at a 20% discount to our PMV of $291, we believe Wall Street does not fully appreciate the underlying cost savings potential from increased automation and acquisition synergies the company will exhibit as volumes continue to rise.
Oaktree Capital Group is a leading global alternative investment management firm with expertise in credit strategies including distressed debt and high-yield bonds. Formed in 1995 by a group including Howard Marks and five other partners from what is now named The TCW Group, Oaktree reported $100.2 billion in assets under management as of year-end.
A Leading Global Alternative Franchise
Oaktree Capital Group is one of the largest and most successful firms in alternative investment management. The company is one of only a handful of firms that has the size and organizational structure to benefit from the continued high level of institutional interest in alternative assets. Oaktree’s competitive advantages include its global platform, experienced investment professionals, and unifying investment philosophy. The Company’s 35 portfolio managers average 23 years at Oaktree and over 813 years of combined industry experience.
Managing Through Volatility
Alternative investment management firms have had favorable economics. The industry has relied on long-term capital to create a stable base of recurring revenues and earnings to generate high levels of return on equity. Oaktree possesses an impressive track record and culture. In contrast to most private equity firms, Oaktree’s focus on distressed investments makes its business somewhat countercyclical.
Tax Reform Opportunity
Most publicly-traded alternative asset management firms are structured as publicly-traded partnerships. As such, they avoid most corporate level tax and do not pay corporate tax on capital gains from the sale of their holdings. In contrast, publicly-traded companies are taxed at the corporate rate. Many investors will not invest in publicly-traded partnerships for a variety of reasons including potentially complex tax reporting. That said, with the recent U.S. corporate tax rate change to 21% from 35%, many firms are performing cost-benefit analyses to determine the structure best suited for their businesses. We would not be surprised if Oaktree concluded that it would be advantageous to pay the corporate tax and become a publicly-traded company. We would argue that new shareholders, along with a high probability of inclusion in the major indexes, could lead to a higher public valuation and subsequent higher share price.
Intrinsic Value Greater Than Sum Of The Parts
In our view, Oaktree’s fundamentals remain solid given attractive secular trends, its strong track record and fundraising momentum. We acknowledge there is little consensus on how to value alternative asset managers. Economic Net Income is volatile and difficult to predict because of mark-to-market gains and losses. Cash carry is also difficult to forecast quarter to quarter. At its current valuation, however, we believe the market is significantly underestimating Oaktree’s structural advantage of having a lengthy lock-up period to implement its strategy, the sustainability of its performance fees, its DoubleLine Capital equity stake, and the countercyclical nature of its business model. Using our “sum of the parts” analysis, we arrive at a private market value of $63. With a March 29, 2018, closing price of $39.60, Oaktree traded at a 37% discount to our private market value and at a P/E multiple of 11.2x.
Investing in small cap and mid cap stocks is more risky and more volatile than investing in large cap stocks. The intrinsic value of the stocks in which the Funds invest may never be recognized by the broader market.
On this page, we candidly discuss three individual companies to illustrate our investment process. These companies are current holdings of certain Funds, one of which was a top performer for the quarter, one was a new addition to a Fund, and the other was, in our view, undervalued by the market. The information and our opinions were current as of March 31, 2018, but are subject to change. The information shown does not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security. These securities do not represent all securities purchased, sold, or recommended to investors during the period. Investors that were not invested in a Fund that held each stock for the entire holding period shown will not have experienced the performance shown. Past performance does not guarantee future results. The performance of any single portfolio holding is no indication of the performance of other portfolio holdings of any Fund or of any particular Fund itself. Portfolio holdings are subject to change. Click here for the top holdings of the Funds.