Alps Alpine Tries Difficult Transition to Higher Margin Products (APELY)

of Japan Alpine Alps (6770.T) (OTCPK:APELY) (OTCPK:APELY) has long been a confusing company to analyze as this company has long struggled to become the market leader in a range of sensor, actuator, switch technologies and display in attractive and durable growth or margins – even with the company leading in areas such as smartphone camera actuators, touch switches for products such as hearing aids, cars and gaming systems, throttle position sensors and so on, the company only managed a low figure in the long term. revenue growth (about 2%) and weak margins and free cash flow generation.

Since my last update, local stocks are up about 12% (with ADRs closer to payout due to currency), outperforming comps/peers such as Sensible (ST), but underperforming MinebeaMitsumi (MNBEY) (6479.T) and TDK (OTCPK:TTDKY)(6762.T). While revenues beat expectations, margins came in big weaker than expected, leading management to launch a fairly comprehensive restructuring program aimed at cutting costs, eliminating lower-margin products and refocusing on higher-margin opportunities.

The best I can say about the stock today is that expectations are very low, especially relative to the company’s market shares in many of its core markets. Long-term revenue and FCF growth of only 2% to 3% (which would assume virtually no improvement from restructuring efforts) may lead to reasonable upside here, but investors should be aware of the risk that the business may not be able to structurally of generating attractive margins and that shares could languish as a result.

Better than expected results against a lower bar

Alps Alpine reported better-than-expected results for its most recent quarter (fiscal first quarter), but it’s worth noting that expectations fell substantially from a year earlier. However, a hit is better than a miss, even if management’s guidance review indicated no expected growth in operating profits.

Revenue was up 7% year-over-year as reported, but down 3% on a constant currency basis. Alps posted pretty good growth from its mobile business (more on that later) and decent results from its automotive side, while consumer was a bit weaker than expected. By segment, the Modules and Systems business grew by 3%, Components by 18% and Sensors and Communications by 4%.

Gross margin improved by about two points (to 17.8%) and operating income reversed the year-ago loss to JPY 1.2 billion, beating expectations of JPY 0.4 billion. The Components business was the main driver of profitability, with segment profits up 373% and margin up more than seven points to 9.8%. Sensor & Communications reversed the year-ago loss (by a margin of 0.5%), while Modules posted a larger loss (a negative 4.5% margin vs. a negative 2.2% in a year ago).

These results led management to raise its first-half revenue guidance by 8% and full-year guidance by approximately 1% (to JPY 925 billion), while its full-year operating income target remained unchanged at 23 billion JPY (or a margin of 2.5%).

Short-term opportunities in mobile, but competition makes it a tougher business

The first-quarter results were boosted by better-than-expected results from the company’s smartphone camera actuator business, which also prompted the revised first-half guidance. While Chinese rivals have been gaining ground at Alps’ expense for several years, it appears to be having trouble ramping up production for the 2024 line of new smartphones. Better yet, with limited capacity, Alps Alpine seems to be getting little to no pushback on price increases (certainly not a typical situation for suppliers to companies like Apple (AAPL) which is helping the company offset inflationary cost pressures of late.

While this is certainly a short-term positive, the phone’s camera actuators don’t really seem to be a major part of the company’s long-term improvement plan. The business isn’t going away and I don’t think management is trying to prioritize it, but for the foreseeable future it looks like the camera features have settled and there isn’t that much chance for the Alps to differentiate themselves from the cheaper Chinese alternatives, especially with OEM are moving away from products like OIS camera drives with distance functions in favor of periscope lenses.

Looking to leverage their capabilities into higher growth and higher margin opportunities

Earlier this year, management launched a plan it hopes will lead to a sustainable and significant improvement in the company’s growth and profitability, including a target return on equity of 10% or more (compared to near-term expectations of around 5 % for FY’26). and FY’27). Major features of this plan include extensive cost reductions (including product development/launch costs and workforce reductions) and a reprioritization of the company’s product strategy.

Management has already moved to exit low-revenue product categories such as airbag sensors and touch panel films, and will also look to selectively exit certain businesses in the seat/door and instrument panel lines. The idea here is basically just addition by subtraction – getting out of businesses that aren’t making profits, let alone earning their cost of capital.

In addition to exiting underperforming lines, management wants to refocus around its strengths in actuation, sensing, image processing, sound and software.

In the components segment, that means an increased focus on gaming, with management explicitly aiming to make gaming (“Entertainment,” as they call it) a third pillar of the business after auto and mobile. In addition to established strength in areas such as haptic actuators (which provide tactile feedback through game controllers) and multi-functional input devices, management is looking to develop products for the emerging/growing VR/AR market.

In Sensors and Communications, management is still looking to leverage its mmWave sensing capabilities to gain share with occupant detection and peripheral object detection in cars, as well as wireless control (remote door opening/closing).

Management is also looking to take its core competencies in sensing and begin to gain share in markets such as robotics – advanced robots increasingly rely on more advanced sensors to optimize positioning and flexibility, and sensitive sensors are vital not only for more complex tasks but also for enabling robots. that can work safely around human beings (robots that can detect a human in their operating area and stop what they are doing). Alps is also looking to leverage its sensing and communications capabilities in areas like logistics and asset tracking – I like the idea conceptually, but Sensata has tried this and gained relatively little traction with it.

With the Module and System segment, management remains focused on its digital cockpit ambitions. For better or worse, this is largely a reiteration of what has long been a strategic priority for management – ​​leveraging its capabilities in sensing, actuation and human-machine interfaces to develop not only automotive infotainment systems, but also complete systems in the cabin that monitor. occupants (including condition detection, such as a driver nodding off or someone sitting in a way that could alter the performance of an airbag) and respond accordingly.

Outlook

Conceptually, I can’t fault Alps’ new strategy – I mean, what’s the argument for staying in businesses where they can’t make a reasonable profit and are becoming increasingly commercialized? Also, looking for new, higher-value market opportunities for high-quality sensing and actuation capabilities is basically a no-brainer for me, and I definitely see a credible market opportunity for actuation and sensing in areas like automation industrial and remote monitoring.

Can management execute? This is the major question. I think they can do better than they did, but a 10% ROE could prove a very difficult barrier to reach in three years’ time.

The flip side is that expectations are quite low, although I do note that there is an unusually wide gap for sell-side expectations (a 12% gap and almost 11% high-to-low for revenue estimates for the next two years), which probably reflects a lot of uncertainty about the extent to which management can execute this higher value-added strategy (and/or the pace of that improvement).

For my part, I’m looking for just over 1% growth over the next three years and long-term growth closer to 3%. I think management can execute this upgrade plan, but I think there will be short-term consequences as business exits will hit results much faster than new market entry attempts. I also believe that legacy businesses like camera phone actuators don’t offer much long-term upside.

I also think margins and free cash flow generation will improve, but I’m only looking for low- to mid-single-digit FCF margins and long-term FCF growth of around 3% (annualized).

These are hopefully conservative assumptions, but still support a potential long-term annual return of over 10%. The stock looks even more undervalued on margin/return approaches such as EV/Revenue and ROE-P/BV. Both margin-driven EV/income and ROE-driven P/BV suggest the stock could double (and that’s assuming there isn’t a big improvement over the next few years), but I’d note that these approaches don’t work that well well on extremes (unusually high/low ROE) and Alps definitely qualifies.

conclusion

It’s difficult to invest with a “well, it can’t get any worse” thesis, because most of the time the market is showing you exactly how bad it can get. That’s not really my thesis here — I think management is doing some smart things to reposition the business for better long-term growth and margin — but I think it’s a relevant comment in the context of what appear to be low expectations.

Is Alps Alpine a dynamic idea? Absolutely not. But the company is at the beginning of what could turn out to be a significant restructuring, and I think more aggressive investors might want to take a look; there’s no need to rush, but I think expectations are at a level where management has a good chance of outperforming over the long term.

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