Logitech International (LOGI)

[FUNMAN]

I found LOGI a few months ago and bought it. This won't be a blockbuster buy, but I did think a company with $2 billion in sales could correct mistakes of it's own making.

Here's an interesting article about the company.



Logitech: A Classic Turnaround Play With Several Growth Catalysts
Jul 16 2013, 14:00

Logitech (LOGI) is best known as a popular PC accessories supplier. However, both the secular decline in the traditional PC segment, coupled with execution missteps in a number of core growth areas, has left the shares trading near multi-year lows as investors appear to have all but given up on the name. I believe that this fear is overdone and that the firm's very credible turnaround strategy, coupled with its healthy balance sheet and leadership brand, should drive significant long-term upside.

The "New" Logitech

What lends credibility to the turnaround strategy at Logitech is that management has been incredibly straightforward in highlighting and clearly communicating the missteps that led the company and its share price to where it is today. While the company's top line certainly wasn't helped by the unexpectedly dramatic decline in the PC market during FY2013, and the bottom line was damaged by both aforementioned PC decline as well as a bevy of restructuring charges, the problem is that Logitech was not prepared for this turn of events.

(click to enlarge)http://static.cdn-seekingalpha.com/uploads/2013/7/16/1095245-13739584717365808-Ashraf-Eassa_origin.png

While these missteps have been deleterious to the fortunes of current, long-term shareholders, I believe that as the company addresses the key issues here, sentiment should improve (yielding a richer forward multiple) and EBITDA should head in the correct direction.

Explaining The Strategy

Management, unsurprisingly, expects that PC unit sales will continue their decline at a 5-10% per annum clip. While I - and management - believe that this may be overly conservative, it certainly doesn't hurt to play it safe, particularly in this continued weak demand environment for PCs. So, it is important to understand how Logitech views each of its businesses and what sort of strategy it plans to pursue with each, as shown in the following slide from its investor day presentation:

(click to enlarge)http://static.cdn-seekingalpha.com/uploads/2013/7/16/1095245-13739778609491174-Ashraf-Eassa_origin.png

As you can clearly see, the "non-growth" areas that are highly levered to the PC such as pointing devices, desktop keyboards, and video conferencing will be optimized for profit maximization as these are either negative or very slow growth businesses, characterized by the following projected CAGRs,

LifeSize (video conferencing): +6%
Audio PC (PC speakers): -7%
PC Keyboards/Desktops: +3%
OEM: -10%
Pointing devices: -5%
Video (think webcams): -10%
In the "growth" category, we see the more "sexy" product lines, characterized by the following (much more attractive) projected CAGRs,

PC gaming (note that while the traditional PC has been faltering, high-end PC gaming has actually been growing): +20%
Audio - Wearables & Wireless: +31%
Tablet Accessories: +45%
The PC Gaming Story: Stagnation And Share Loss Can Be Reversed

It is interesting that despite the apparent secular decline in the PC space, the PC gaming space has continued to do quite well on all fronts. Nvidia (NVDA), for example, continues to buck the trend of slowing PC sales as it continues to print money with its high end, gaming oriented GPU. Intel (INTC), too, is beginning to realize that significantly improving the graphics performance on its integrated processors is of paramount importance from a user experience standpoint. As such, the broad market for PC gaming peripherals remains strong.

While Logitech actually has significant market segment share in the PC gaming peripherals space, said share has exhibited an unhealthy trend,

(click to enlarge)http://static.cdn-seekingalpha.com/uploads/2013/7/16/1095245-13739794726286979-Ashraf-Eassa_origin.png

Now, in another bit of brutal honesty, the company made it clear that this share loss was a result of a weak product lineup with gaps in the lineup. Logitech also believes that its relatively weak customer engagement efforts carry some of the blame. Despite this, the company still retains #1 or #2 market share position in a number of key markets (Germany, USA, China, Sweden, Japan, and Australia).

This is where the opportunity comes in: when you have a well-known and well-liked brand that has made such an "obvious" set of oversights and is actively working to remedy these problems, there is real room for upside. Consider that the PC gaming peripherals market has been growing at a 28% CAGR over the last several years:

(click to enlarge)http://static.cdn-seekingalpha.com/uploads/2013/7/16/1095245-13739802759826572-Ashraf-Eassa_origin.png

This means that this growth segment is supported by two tailwinds: a stronger competitive positioning from a market leader that has been in a slump paired with a growing demand environment.

The Tablet Growth Story: I Believe Management Is Being Conservative

A major bright spot for Logitech has been the growth story in tablet accessories. According to the company, the iPad accessories market is worth $1.4B alone, and the Android accessories market is worth an incremental $513M. In this space, Logitech currently focuses on tablet keyboards ($350M/yr TAM) and cases ($1.4B/yr TAM). This plays right into Logitech's strength as a leading PC keyboard vendor, and it comes as no surprise that the company has the best-selling iPad keyboard.

However, this isn't enough, as the company recognizes the need for more rapid product development cycles. In the traditional PC accessories space, the typical product development cycle is 12 months and the typical product life cycle is 24-36 months. In the faster-paced tablet market, the product development cycle needs to be on the order of 3-6 months and the products can be expected to last for 6-12 months. One of the major keys to success is simply having a product on the shelves in tandem with the major device introduction.

Speaking of the shelves, the final major point in the company's strategy is to expand its retail presence. The company aims to focus on the leading retailers in 13 countries and achieve placement (and shelf-space share) at roughly 5,000 retail storefronts and online sites.

Now, there are a few additional tailwinds that I see for Logitech in this space going forward. The first is that the company has economies of scale against its numerous smaller competitors, which suggests that while gross margins in this space will not be particularly fat, Logitech could have a non-trivial advantage over its competition, which could allow it to successfully compete on price if the premium brand/aesthetics story is not as strong as hoped. Next, I expect that as Windows 8 tablets and convertibles gain momentum, there will be significant room for Logitech to leverage its traditional Windows PC heritage and name to play in this space, opening up another revenue stream on top of the iOS and Android opportunities.

The Ultimate Ears Opportunity

The final major growth opportunity, in audio wearables and wireless, is an interesting one. Logitech doesn't market products in this space under its own name, and instead chooses to sell products under the Ultimate Ears brand, as this space appears to require an "authentic" music brand. Essentially, this division sells two lines of products: wireless speakers, and premium earphones. According to the company, the wireless speaker segment is projected to grow at a 63% CAGR through FY2016.

I believe that the company is well positioned to take advantage of the wireless speaker opportunity. Mere participation in this market almost guarantees that the company will ride the secular growth wave, but if Logitech can actually bring to bear a legitimate competitive advantage (which the firm claims it has), then - similarly to the PC gaming opportunity - this lends itself to a market share gain in a secular growth environment story.

The earphone market doesn't exhibit the robust growth opportunity that the wireless speaker opportunity presents, but Logitech will be primarily targeting the higher end premium earphone segment, where the company can differentiate and command higher ASPs/margins than in the more commodity mainstream portions of the market.

Tying It All Together

Logitech certainly had a rough FY2013 and FY2014 will represent a "reset" as the declines in the firm's core PC business do not yet begin to be fully offset by the new growth opportunities. As a result, particularly as this is a name in "turnaround mode," the name is likely to look somewhat expensive in the near term. The company has set FY2014 full year operating income guidance at $50M, which suggests an EV/operating income multiple of 14x - not particularly cheap. However, the company has set a particularly firm FY2016E target of $150M of operating income.

While there is certainly risk inherent to basing a valuation on estimates that go rather far out, I believe that given that this estimate bakes in a pessimistic 5-10% unit decline in the PC space through FY2016E and seems to be based on conservative estimates for the end market growth in its growth businesses, the company is likely to hit these estimates. Should it do so, I believe that the shares would look quite cheap at a 4.91x FY2016E EV/operating income multiple. Further, this projection is not baking in any outrageous top-line growth estimates; indeed, the FY2016 projection assumes revenues of $2.25B, which would represent a modest 12% growth over FY2014. There is an operational efficiency story that, following the recent restructuring, is likely to play out here.

Assuming that by FY2016E sentiment has improved (but has not gotten wildly unrealistic), leading to an EV/operating income multiple of between 10-12x (shares have historically traded at 7-17x EV/EBITDA), it does not seem too aggressive to expect shares to trade between $9.40 - $11.30/share, suggesting 40% - 67% upside from here by the end of FY2016. I further believe that in these types of cases, expectations could lead results, so achieving an expansion in the multiple on FY2016E expectations could be achieved as soon as it has become clear that the turnaround is tracking to plan. Interestingly, at Logitech's recent investor day, the following interesting slide was shown regarding the FY2016 (click to enlarge)http://static.cdn-seekingalpha.com/uploads/2013/7/16/1095245-13739947499384568-Ashraf-Eassa_origin.png

So, while investors wait for the "endgame" where operating margin nearly triples and revenues see a modest bounce, FY2015 (we are in the first quarter of FY2014) should still see operating margin nearly double on a very modest expected improvement in sales. Even at our modest 10x - 12x EV/operating income target, and even if the Street would rather not look farther out to FY2016E, we could still see conservative upside to $7.70/share - $8.80/share (15% - 30% upside) depending on how well the firm is executing towards specific market share/growth targets, and how much confidence management exudes at the quarterly calls throughout the year. Of course, given management's conservative estimates about PC unit declines throughout the next several years, there is room for upside in the actual results should the decline show signs of slowing down, or if the upcoming new product refresh mentioned on the most recent call for this space can drive a peripheral refresh independently of new PC sales.

It is useful to use Logitech's historical multiples in this case, as very few of Logitech's competitors are publicly traded, and those that are usually compete against only one segment of Logitech's business (for instance, ZAGG (ZAGG), which trades at ~4x EV/EBITDA, but competes primarily in iPad/Android keyboards)