Pace — A Free Cash Flow Story

UK technology giant Pace is one of a few large caps that suffers from a perception problem; whilst demonstrating numerous sound fundamentals qualities, the valuation relative to peers within Europe and (unsurprisingly) in North America is comparatively very low, despite the more attractive free cash flow yield versus most. Although the share price is struggled on a one-year basis — declining by just shy of 6% — the share price performance since 2012 (over which period the share price has almost tripled) is testimony to the strong operational turnaround within the business. However, the market still appears at unease with the operational model of Pace, and that appears harsh.

Technicals

From a technical perspective, Pace is fairly attractive as an entry point, conditional on there being no break below the upward sloping support at circa 330p. The share price finished an exhaustive downward trend in early October with 300p holding up as support characterised by buying volumes being above average, causing a ‘hammering out’ of a low, followed by a quick rebound. That has since been backed up by fundamental news.

However, whilst the overall picture suggests the stock is primed to the upside (through an ascending triangle off that low of

300p), it is conditional on a break above 350p being sustained whilst the 50dSMA has time to convincingly surpass the 200dSMA; that would suggest the start of a new medium-term upward trend towards 400p as a first port of call (market conditions allowing). The MACD and RSI have are also shown to be in a narrow zone, which is typical of a stock pre-breakout, especially when support and resistance lines tally, as they do with Pace in this instance.

The shareholder structure of Pace is characterised by significant institutional interest, as is to be expected for a large cap over 1 billion, with M&G, Prudential, Schroders and Old Mutual all holding notifiable stakes. Broker targets for Pace stretch between Numis’ Hold recommendation and 360p price target, and Canaccord Genuity who have a 457p target price and a Buy recommendation. The spread on Pace is relatively narrow at 340.70p — 341.00p.

Operations

Pace is a company with global presence with revenues spanning most continents with a particular weighting towards the US where they derive just over 3/5ths of revenues. Pre-acquisition of Aurora Networks, the company is primarily involved in the manufacture and distribution of various customer premises equipment (i.e. in-the-home products) such as set-top boxes, media servers and gateways. Those products are provided to well over 200 customers including industry majors such as Sky, Liberty Global, Telefonica and DIRECTV who customise the hardware and internal software, and roll it out to the customers who wish to purchase subscription channels or content. With PayTV subscriber growth at double digits per annum, it’s an increasing industry, particularly in emerging markets such as Latin America and Asia.

A separate segment of the business (albeit a relatively small one) is the Software side, which is being expanded through diversification plans; this includes the Pace Elements platform that has functions enabling customers such as those aforementioned to design and deliver media user interfaces in a secure manner.

The problem Pace has faced, and continues to face, is that the market sees set-top boxes — which account for a significant proportion of revenues — as a declining market where, for example, Smart TV’s will reduce the need for them to exist. That is driven by an underlying shift towards — particularly video — content being delivered Over The Top (OTT), and there are residual concerns that Pace’s focus on assisting majors through subscription TV hardware could lead to revenue sustainability issues.

OTT refers to the delivery of services over the open internet straight from the provider/creator in an unmanaged fashion. For example, the proliferation of Youtube (for user generated content), Amazon (as a content retailer) and BBC iPlayer (as Traditional Broadcasters widening their scope) are just three competitors to the traditional TV and Subscription TV models.

The reality is that Pace’s products are a managed service in that they are interconnected with the software framework hence can be updated or patched as of when is required. Furthermore, unlike with the unmanaged content, the quality of service can be guaranteed through set-top boxes. Consequently, set-top boxes remain very much an integral part of many companies offerings and Pace continues to provide the latest generation products (largely internally developed) with ever-improving functionality. That is not functionality that is readily available in Smart TVs or other currently available solutions, especially given the drive to create ever-thinner TV screens. Bundling together those products also means that you cannot switch a set-top box if you purchase a new television. Furthermore it is currently used for the optional extras (i.e. the subscription service), so it makes little sense to force purchase if it is less practicable. Whether that payment method will evolve remains to be seen.

For example, smaller competitor Amino Technologies has integrated a home automation solution into so that its set-top box acts as a central hub for various in-home cameras and other devices. Consequently, set-top boxes and OTT services are not widely considered as mutually exclusive devices and OTT actually allows subscription TV providers to offer a wider range of services such as video-on-demand, which if anything enhances the user experience. The most generally considered sector to lose out from this move into OTT is the DVD rental market. Nonetheless, it is a factor to consider.

Aside from this, Pace has made inroads into adjacent markets by virtue of its excellent cash generation abilities. It has undertaken several acquisitions since the financial crisis, with a highly interesting one being the acquisition of Aurora Networks; this moved Pace up given it was a vertically integrated acquisition that provided exposure to networks outside of the home. Aurora is a leading supplier of optical transport and access Network solutions to cable operators; products include fibre transmitters and optical nodes.

The acquisition was completed in early 2014 in a deal with headline $310m in cash, which at valuation metrics of $217m in revenues and roughly $30m in EBITDA, put the transaction multiples at 1.43x sales and 8.2x EBITDA post-synergies. Contrary to the unclear demand for set-top boxes, the acquisition positioned Pace to exploit the long-term likely trend in ever-increasing consumer demand for bandwidth. Whilst currently the average home has between 3 and 6 connected devices, that figure is expected to rise significantly to around 50 within the next decade, driven by an increasing trend towards home automation and interest in technology. Furthermore, the demand for Aurora’s products, which has been above expectations for the last financial period, has been driven by increasing network upgrades and new fibre deployments.

As a result of this diversification, and contrary to market opinion, Pace insists that it is well placed for major industry trends, with various growth paths amongst those detailed, and also as a leading Reference Design Kit (RDK) vendor; this is a software bundle providing a common framework for powering customer premises equipment.

Perhaps most impressively has been the feat of Mike Pulli’s management team to outperform their strategic plan over the past few years. The supply train has been trimmed to two core suppliers, operating expenses are down 16% and working capital is down almost 70%, giving rise to the excellent cash flows noted previously. With a continued focus on product development, Pace has positioned itself as a global market leader within the set-top box and DSL gateway markets (by value), and media servers market by volume. That is a strong accolade given the competitors in each segment, which includes Cisco in set-top boxes and Huawei in DSL gateway.

The progress being made can be seen in a number of recent contract wins with Comcast starting to deploy the latest Pace Xi3 IP Client set-top box, continued progress with AT&T to develop and deploy a new range of DVR set-top boxes and new residential gateways, and being selected by Brazil’s DVT to provide a next-generation GPON gateway and selection of set-top box products.

The one negative released concurrently with the last set of interim results is that Chief Financial Officer (CFO) Roddy Murray stepped down with immediate effect (which is rarely a good sign). However, a capable replacement has been appointed in the form of Mark Shuttleworth who formerly was the CFO of well-known Emirates Telecoms company ‘du’, and assisted in leading from a $660m IPO to a market capitalisation of $8 billion. In a more concrete way, results post-resignation have been highly positive.

Commenting in a January 2015 trading statement, Mike Pulli, CEO, set an upbeat tone saying: Pace has performed very well in 2014 with a particularly strong second half to the year. We have launched a record number of products across the globe and continue to lead the market in both product innovation and the service we deliver to our customers. Demand from our customers has remained strong and we continue to win new business. The Company has made further good progress in the execution of our Strategic Plan and has achieved improved profitability and strong cash generation for the third year in a row.

The Aurora Networks acquisition has performed above expectations and has enabled Pace to widen out into the network infrastructure space and build deeper, more embedded relationships with our customers. The Board are confident that, through Aurora, potential further acquisitions and the ongoing delivery of our Strategic Plan, Pace will further strengthen its position as a market leading solutions provider for the PayTV and broadband industries.

We have good momentum and are confident of making further progress in 2015 and beyond.

Financials

Given the market perception of stagnant growth and concerns regarding future growth, it is not surprising to see the latest set of interim results showing declining sales. However, that was down to exclusivity agreements lapsing with certain customers plus flat/weak revenues elsewhere in set-top boxes, reduced legacy demand for gateways ahead of new product launches, and a major customer for gateways starting to dual-source their products. That is reflected in revenues from all regions except the Rest of the World showing falls, so it is understandable that the market is taking a cautious approach in the near-term following the run-up to over 450p. Impressively though, EBITA and the operating margin showed significant increases. Headline figures are as below:

- Revenues down 13.6% to $1,138.9m

- EBITA up 9.9% to $106.3m

- Adjusted Operating Margin up 2% to 9.3%

- Free-Cash Flow of $108.9m equating to 102% of EBITA

- Net debt of $167.6m

The attractiveness of Pace from a financial perspective can be summed up in one metric; free cash flow yield. Following numerous guidance increases during the second half of the year, free cash flow for 2014 is expected to exceed $200m, and despite the decline in revenues it should challenge the $209m in free cash flows (FCF) posted in 2013. That gives a FCF yield north of 12% on a debt-free cash-free basis, which is where Pace should be at the end of H1 2015. The strong cash flows themselves enable significant value creation, or a swing in sentiment; the launch of a share buyback would be sufficient to swing momentum back towards the bulls, but long-term value creation would be through another acquisition of a similar size to Aurora.

The high FCF yield is not resulting from a high level of debt either, with a sound balance sheet showing 1.2x more current assets than current liabilities, or current assets totalling 0.74x total liabilities. Tangible assets were 0.8x total liabilities and with the cash stacking onto the balance sheet each half-year, that multiple should continue to increase. Therefore, if Pace were to just stand still for 5 years, and broadly maintain its current market position, it would likely generate more than at least 600m in distributable cash, or more than 50% of the current market capitalisation, ceteris paribus.

The rationale for that creating value is derived from the FCF yield, and an extremely modest set of other profitability ratios such as the price-earnings ratio. Following the January trading update, Pace suggested that adjusted basic earnings per share would be at least 56 cents or 37p at current exchange rates, putting the company on a price-earnings ratio of just 9.2. As a consequence of the FCFs, net debt would also be less than $95m at the end of the 2014 calendar year, with adjusted EBITA up nearly 25% year-on-year to $240m.

The above shows the trends of revenues, FCF, adjusted EBITA and the net debt since 2010. Of particular note is that the FCF estimate for 2014 is the minimum possible value, and should test the figure of $209m posted in 2013, based on sensible EBITA conversion assumptions. What is not shown in the graph is that the underlying operating margin has risen from around 6.7% in 2010 to the 9.2% forecast for 2014, which again underscores the strong market position and product proposition that Pace offers. Encouragingly the board of Pace have a track record of outperforming market guidance with in excess of seven earnings upgrade announcements since late 2011 when executive management changes occurred (including the introduction of Mike Pulli). That creditable performance has been seen in H2 with both the top line and profitability strong, albeit it does highlight the volatility in some of the financial metrics from half-to-half.

Circa 78% of those revenues were from the set-top boxes and media servers segment with networks (through Aurora) the next largest at 10% and Gateways in third at

6.75%. Whilst Pace does run a hedging scheme to offset major exchange rate fluctuations in currencies such as the Brazilian Real, there is an earnings quality question mark arising from customer dependency where Comcast, AT&T and DIRECTV account for nearly 60% of revenues. This is very much an issue I previously highlighted with Amino Technologies (LSE:AMO) when trading at circa 90p/share and when it was trading on a relatively low single-digit ex-cash PE Ratio. Similarly, Amino is a set-top box maker and has high customer dependency in that a few customers account for a significant proportion of revenue.

The difference between Amino and Pace is one of scale; Pace is the largest set-top box maker by volumes (as noted earlier), hence they become a supplier of choice simply through recognition, especially given the excellent product and management team. That assists in Pace’s ability to retain customers for lengthy periods of time and through cycles of product generation. Similarly, that customer dependency factor does filter through to Aurora, with their top 10 customers controlling nearly 70% of revenues; again, the niche that Aurora has carved out in terms of its proprietary technology leaves it in good stead, and their 30 consecutive quarters of profitability underlines that.

However, the concern with Pace is deemed to be more substantial given recent sector consolidation in the US, with Comcast and Time Warner Cable merging and AT&T buying DIRECTV. Although the former deal is currently on hold pending regulatory approval, there is potential for the mergers to be disruptive to the supply chain with Pace affected. In reality, that concern is likely overestimated. AT&T and DIRECTV have already committed to keeping separate services for at least three years from the date of deal closure in 2014, plus Pace is in the supply chain of both, so it’s a sensible assumption to believe that Pace is well placed for order of the enlarged group. Secondly, Time Warner Cable would likely take-up Comcast’s platform directly, which Pace supplies, and of course that deal is not close to closure yet. Chip vendor Broadcom, which is in a similar supply chain situation, has gone as far to comment that said deals were neutral to positive on their outlook.

In terms of competitor metrics, Amino Technologies trades on broadly similar metrics to Pace at the enterprise value level with a slightly lower FCF yield and a slightly higher price-earnings ratio ex-cash. However, the dividend yield is superior to Pace by a clear margin (3.8% forecast for Amino in 2015). That said, Amino does have a scale risk relative to Pace, as commented earlier. Internationally, Arris, Harmonic Inc, and Technicolor are three competitors, and when combined with similar companies internationally, they form an average price-earnings ratio (of the profitable companies) north of 16. That is despite several having very similar business models to Pace in that there is a significant proportion of revenues derived from set-top boxes.

Those discounts to the sector should narrow; the return to net cash with Pace should either be followed by a material acquisition, share buyback, or through an appreciable rise in the currently token dividend yield. At the current set of valuation metrics, a decline in revenues of as much as 15% from current levels and an associated decline in adjusted earnings per share of as much as 30%; those metrics would still leave Pace at a discount to the sector and on a PER of 13 on adjusted basic EPS of 26p. Earnings forecasts for 2015 are essentially low-single digit or flat across the board; this is where an earnings-enhancing acquisition would likely see forecasts comfortably beaten. An acquisition appears the preferable option of the board.

Positively, the board are confident of the future of Pace noting that PayTV markets continue to perform well and demand for Pace’s products and services is growing. and that The Company continues to make further progress on its self-help initiatives with improvements in the efficiency of its supply chain and a reduction in operating costs. Notwithstanding the benefits realised over the last three years, there remains significant opportunity for further improvement.

An Excellent Set of Financials

Contrary to investor scepticism — which largely explains the modest valuation at present — the markets that Pace operates in remain robust and that is reflected in the narrative produced by management alongside several earnings beats recently released. The assumption by the market that growth will simply flatline without response from the company seems naïve, especially given the strong track record of Pace since late 2011 after the introduction of Mike Pulli. The free cash flow presents the company with a plethora of value creating opportunities that at the current valuation — which is amongst the lowest in its sector within Europe for its size — could generate appreciable upside as detailed earlier in the review. From a charting perspective, the share price looks well positioned for a breakout acting as a catalyst for a medium-term trend change, and with recent news reporting results to be above expectations, I would expect this to be to the upside. The set of financials that Pace boasts is excellent and from the present level the risk-reward is sound. I have therefore put a Buy tag on Pace at 341.1p.