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'Better late than never' are four of the most dangerous words in investing. More money has been lost jumping on long departed bandwagons than perhaps in any other area.
· Ambitious plan to transform PCB industry
· Could provide many years of strong growth
· But little margin of safety
Altium, a producer of software to help design printed circuit boards (see ShopTalk), certainly has that feel about it. When I first took a serious look at the company in 2014 it looked like a promising business. However, with a market share of barely 15% and some heavyweight competitors, it still had a lot to prove - particularly at a (stratospheric for the times) price-earnings ratio of around 30.
Prove it, though, it has. This year the company is expected to move into a market leadership position, having almost doubled its share over six years while its competitors have all gone backwards. Earnings have risen sixfold and the share price more than tenfold (see Chart 1).
It's hard to pinpoint the reasons for this success. The company's historic emphasis on lower and middle market users has ensured a strong familiarity with its software. Its singular focus on PCB design software may also have helped (while competitors have been distracted by tools for designing chips as opposed to the boards they go into). The consensus seems to be that Altium's tools have always been easier to use and that it has caught up in terms of advanced features to give it a superior product across the (ahem) board.
It's difficult to verify all this (we'd love to hear from anyone with industry knowledge in the comments below), but to some extent the proof of the pudding is in the eating. As you can see from Chart 2, Altium has clearly been doing something right - and we'd expect the momentum from that to carry it into a dominant industry position over the next few years.
Printed circuit boards are the (usually) green or brown plasticky things that hold the electronics in products. In the early days of electronics, the components were attached to a simple board, along with a jumble of wiring (as in this early TV set), but that quickly became unworkable. The connections, called 'traces', are now directly etched onto boards, and holes are custom-drilled to accommodate the components. Modern PCBs can be highly intricate and spread over several layers, necessitating sophisticated design tools.
So, whilst congratulating those who jumped aboard this bandwagon, we must surely now acknowledge that it has left us for dust?
Well maybe not. With the miniaturisation of electronic products into things like wearable devices and ever-smaller phones, PCBs increasingly need to be put together with the mechanical design of products - their overall size and shape - in mind. Components also need to be selected carefully to balance performance within the constraints of power and heat generation, as well as cost and availability.
This is the big opportunity. Currently, the PCB industry is split into three segments - the design of the boards, their manufacture, and the supply of the components that go into them. So a designer might specify a component from the library siloed within their design tool only to find later that it's out of stock; or they might find that a PCB no longer fits into a product due to a last-minute tweak in its overall shape.
Altium wants to use its (anticipated) market dominance to 'unify and connect' the different segments so they can work together more effectively. So a mechanical engineer will be able to keep tabs on the PCB design while fine-tuning a product's overall form (and vice versa); and the PCB designer will be able to search for suitable components directly from within the design software, getting live information on availability and submitting an order.
The company's new cloud product, Altium 365, released last year, will be crucial to its plans. Initially available for free, the aim is for Altium 365 to become ubiquitous throughout the industry, with the various participants using it to share designs.
When enough people are using the product, the next step will be to get customers to actually shift their design data onto the cloud, so people can collaborate in real-time. By 2025 it is hoped that Altium will be entrenched across all stages of PCB design and manufacturing.
Octopart, an electronics component search engine acquired by Altium in 2015, is another important part of the plan. Not only does it increase the usefulness of Altium's product, but it provides another revenue channel, through search advertising revenues from component manufacturers. Further acquisitions are likely, to fill in any gaps in the stated transformation strategy, but we'd expect them to be relatively small.
Management is open about the fact that it will need 'dominance to the point of virtual monopoly' in order to drive this strategy. Chief executive Aram Mirkazemi said in December's technology presentation that he 'didn't want to leave any space for any competitor to stay in business' before chortling slightly, but we don't imagine for a moment that he was joking.
So the plans are unlikely to be welcomed by competitors, but what about customers? Will they really accept being beholden to one company to supply their design software?
Mirkazemi things they will, as a necessary evil in order to get the productivity enhancements. After all, the design software is only a relatively small cost - the more important thing, for customers, is to come up with the best products as quickly as possible. He likens it to Adobe Photoshop. '[If the industry] can standardize on one product,' he explained at last August's results announcement, 'then they can transform. But whilst you have disparate products and different vendors, it's very difficult to go forward. So I think the industry will embrace this.'
Altium thinks the necessary dominance will mean a doubling of subscription numbers from this year's expected 50,000 to 100,000 by 2025, and a resulting increase in revenue from around $200m to $500m.
On the way there, the company plans to follow the 'rule of 50', by keeping the sum of its revenue growth rate and EBITDA margin to at least 50%. The idea is to allow flexibility for the company to invest to support any sudden bursts of revenue growth. If it all pans out, we'd expect earnings per share to expand by around 20% a year for the next five years, to about $1.64 in 2025.
These are ambitious targets, but management has earned the right to a bit of faith. Mirkazemi himself is an impressive character. When he arrived in Australia as a refugee from Iran in the 1980s he was unable to speak English, but he began an engineering course at the Univeristy of Tasmania within six weeks. 'The first month was technical drawings and I'd sit in class and just watch the lecturer ... and I would try and figure out what the problem was ... just by looking at the drawings.'
From 1990 to 2000 he worked at Altium (then known as Protel), ultimately as head of research and development, before leaving following the company's float. He then established Morfik Technology, a developer of cloud application design tools which was bought by Altium in 2010. Altium was already using Morfik's tools and said the acquisition was necessary to bolster its engineering team and accelerate the development of its cloud platform.
Mirkazemi was duly appointed Altium's head of engineering, then chief technical officer and finally chief executive in 2014. Since then he has consistently hit performance targets - watching his 7% stake in the company swell to almost $400m.
The current chief technology officer is Sergei Kostynsky, also from Morfik and with almost 2% of the company; and the chief sales officer is Henry Potts, who previously led competitor Mentor Graphics when it had a 50% market share.
If anyone is going to drive this kind of transformation, you'd have to back this management team.
So while this bandwagon has no doubt departed, it could have a long way to run. Unfortunately, the ticket price for latecomers looks daunting, at around 60 times this year's expected earnings and 24 times those that might be achieved in 2025 if management successfully executes its strategy.
To justify that kind of price you'd have to expect strong rates of growth to continue well beyond that. If you do, then it might make sense to buy a small position - perhaps 1-2% of your portfolio - even at current prices.
For most members, though, we'd recommend waiting for a greater margin of safety. As things stand, we'd start to get interested below about $30 (implying a current year price-earnings multiple of closer to 40), but that number will change as the company does - or does not - deliver on its goals.
We won't be formally adding the stock to our coverage list at this stage, but we'll be keeping an eye on it in the hope of an opportunity.
Disclosure: The author owns shares in Altium.