A circuit breaking stock with a bright future

Jun Bei Liu

Tribeca Investment Partners

Altium is a highly profitable growth company that operates in the global engineering software applications market, with a specialisation in the Printed Circuit Board (PCB) design software. The company was listed in 1999 and has a long history of double-digit profit growth and consistent strong free cash flow generation.

Altium operates in an attractive market. The total PCB tools industry has enjoyed rapid growth for the past decade underpinned by the extraordinary growth in everything electronic – from consumer electronic devices to electric vehicles to military and aerospace applications – just to name a few categories.

The company is well-positioned to ride the strong secular growth trend in demand for products containing PCBs over the coming decades. In our view, this makes it more defensive than many other growth stocks.

A clear buying opportunity

Altium is amongst the largest players in the PCB market, which includes global mega-cap Cadence Design Systems (CDNS US), Mentor (acquired by Siemens in 2016) and Zuken (6947.T).

It has roughly doubled its market share since 2014 to approximately 13%. We expect the strong growth trajectory to continue over the next five years as it continues to win market share. The share gains reflect the strength of the group’s offering and its competitive pricing. We expect the group's cloud-based solution to receive a boosted from COVID-19 and the widespread shift to working from home.

A more challenging but potentially lucrative prospect for the business is its operations in China. Currently, unlicensed versions of the group’s design software are widely used. The company is working to convert at least some of these users to its licensed offerings.

We are also confident the group will be able to maintain its attractive 35% margins given the low delivery costs of software services and its already competitive pricing model. After a period of rapid cost growth in recent years, we expect the maintenance of margin will also be supported by increasing scale and adoption of the cloud-based solution.

Recent share price fall of close to 30% in the past 2 months represent a clear buying opportunity.

Source: Iress

Just before the global outbreak of Covid-19, Altium’s share price had more than doubled in the last 2 years to reach a peak of $42, making it one of the best performing stock on the ASX. Even post the sharp market sell-off, Altium’s total price return is still in access of 60% over two years.

Impacts from COVID-19

Like most businesses, Altium’s revenue will be impacted by the fall-out from the COVID-19 pandemic. This was confirmed in early April when management withdrew its FY20 guidance (revenue growth of 20-25% and EBITDA growth of 20-30%) due to “the rapidly evolving COVID-19 environment”.

However, given more than half of the group’s revenues come from recurring or subscription-based fees, we still expect mid-teens revenue growth delivering a result only marginally below the bottom end of the previous guidance range. Earnings are likely to be supplemented by a focus on reducing costs after a few years of a rapid expansion of the cost base.

Growth opportunity remains even in a weaker economy

Looking to FY21 we expect growth in the end market for products requiring PBCs to slow due to weaker economic conditions. However, we are confident the broader trends in the PCB industry remain robust. This reflects our view that the exponential growth in Internet of Things (IoT) devices and explosion in AI are likely to continue almost irrespective of economic conditions.

We expect the economic pressures to work in Altium’s favour given the affordability of its offering. With the company having recently rolled out a new cloud platform we also expect it to benefit from accelerated adoption of cloud technology in the PCB design industry given the shift to working from home caused by COVID-19. Overall we are confident a combination of more modest market growth but solid gains in market share will ensure the strong revenue trends continue. These are not included in most forecasts nor valuations.

We also see an opportunity for management to rein in its spending. The group has a history of reducing its cost base effectively during previous downturns. We expect this will again be a focus in FY21.

In our base case, we foresee revenue and earnings growth for Altium in 2020 even in the face of a global recession. This view was bolstered by the commentary from NASDAQ listed Cadence Design Systems at its recent Q1 result last week. The company re-iterated CY20 revenue guidance for around 10% growth in revenue. In addition given the group’s strong balance sheet, the business is well-positioned to weather the downturn.

The China opportunity

Like many software companies, Altium has long recognised there is a large number of user of unlicensed version of its software. The company has tried to deal with this issue by offering upgrades to entice more licensed users. Most recently it has launched ALU365 free version of its software in an effort to drive more users to high-value recurring subscriptions.

The big opportunity to attract more revenues is in China where only a small minority of users of the group’s software pay. While this is clearly a challenging proposition, especially in a weaker economic environment, the opportunity is large.

Valuation well above the current share price

At 31 December 2019, they had a cash balance of $80m, with zero debt. The business has been free cash flow positive every year for over a decade. So unlike many other businesses we see no risk it will need to come back to the market for additional equity.

Given Altium’s strong growth trajectory and the size of the market opportunity, we firmly believe the appropriate valuation method is discounted cash flow. This allows the strong future earnings growth potential to be fully captured.

Given the likely short term nature of the COVID-19 impact, the current downturn has only a minor impact on our valuation. With the recent share price decline, the stock is now trading well below our valuation and hence represents an attractive investment opportunity.

Our target price of $42 implies a return of nearly 30%. As discussed earlier, the market has been concerned over Altium’s short term revenue disruption. This presents an opportunity for those to look through what is likely a one-off event. After all, history tells us global pandemics are rare events!

In summary, Altium is a high-quality business that offers strong earnings growth underpinned by structural demand drivers and an opportunity to rapidly expand its market share. While market-wide conditions are likely to become more challenging, growth is likely to continue.

We are confident Altium will be able to offset a slowing market growth with share gains reflecting its competitive offering. The recent drop in the share price provides an opportunity to buy a great growth story at an attractive price. 

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Jun Bei Liu
Lead Portfolio Manager Alpha Plus Fund
Tribeca Investment Partners

Jun Bei Liu is the Portfolio Manager of the Tribeca Alpha Plus Fund, one of Australia's longest running equity long short funds. Jun Bei Liu is a passionate investor with over 18 years of Investment experience covering a large range of sectors, an...

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