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This work was originally published on SumZero on February 18, 2021.
I don't look to jump over seven-foot bars; I look around for one-foot bars that I can step over.
Telsys (TLSY:IT) Investment Thesis
A highly profitable hardware manufacturer growing sales 25% a year for almost 2 decades can be bought at a reasonable price; a likely 2021 Nasdaq listing could unlock more value.
Current price: 138.28 NIS per share
Target price: 244 NIS per share, 77% potential upside
- Founded in 1963 and public since 1992, Telsys has a legacy hardware distribution business in Israel and trades on the Tel Aviv Stock Exchange (TASE).
- Telsys is a small cap by Israeli standards, with a current market cap of 888 million NIS (~274M USD).
- Telsys was founded by Thomas Yagoda, and his family and partners continue to control the company today, insiders have plenty of skin in the game holding 43% of the company.
- Telsys also owns ~70% of Variscite, a growing prominent player in the global System-on-Module (SoM) market.
- Variscite, founded in 2003, has been growing sales at a CAGR of 25% for the last 17 years, a trend we believe will continue for the foreseeable future; in fact, in the last 5 years, growth rate has accelerated.
- Variscite is extremely profitable, displaying high growth rates, and its current run rate suggests 2020 sales should reach $56M with an estimated 42% operating margin and EBIT reaching ~$23.5M.
- Variscite’s business model relies on negative working capital, so earnings are primarily converted into free cash flow, and with no need to increase working capital to finance growth, Telsys pays a 5% dividend yield.
- Current market price implies one can buy Telsys’s stake in Variscite for a free cash flow multiple of 18; additionally, we believe there is a high probability that sales and free cash flow will double in the next three years.
- In 2019, speaking to investors for the first time in many years, management expressed a Nasdaq listing as a future goal – we believe this will be a 2021 event and perhaps will result in a multiple re-rate for Telsys.
- We view Variscite as a good candidate for Nasdaq listing because although it is listed in Israel on the TASE, Variscite is essentially an international company with global clientele.
- We also view Variscite as a unique, profitable, cash-generating growth story and believe it will appeal to Nasdaq investors.
*Israel’s currency is the New Israeli Shekel (NIS) ₪. 1 USD = 3.24NIS as of February 16, 2021.
Variscite and the System-on-Module (SoM) market
What is an SoM?
From Wikipedia [sic]: “A system on a module (SOM) is a board-level circuit that integrates a system function in a single module. It may integrate digital and analog functions on a single board.”
In other words, the modules are electronic boards on which main components of a standard electronic system, such as a central processing unit (CPU), microcontrollers, memory, audio and video cards, are installed. The SoM niche market is part of the broader computer board market.
Clients who buy SoMs are hardware manufacturers designing and producing electronic products. A client will buy an SoM from Variscite for use as a building block for another electronic product, such as a tactical GPS navigation unit, smart glasses, a coffee machine, a treadmill or a medical ventilator.
Clients typically buying an off the shelf SoM need to design and manufacture up to 50,000 units of a hardware product. Above that number, it is usually more effective to develop the module internally.
How does an SoM client interact with a company like Variscite?
Let’s use an example of a client designing a medical monitor able to communicate in real time with various medical sensors and to display all the data graphically on a screen. The client finds a generally suitable SoM from Variscite’s existing catalogue then orders it online with a process of customization. For example, perhaps the client would like the monitor to transmit data wirelessly, so a relevant component will need to be added to the SoM.
Following customization, the client pays an advance of 50% of the order value and then the order moves to production. Once a client chooses its SoM supplier, it is basically locked into using the same SoM for as long as the product is manufactured, as replacing an SoM is an expensive and potentially harmful process.
Typically, an SoM unit is sold at a price range of $50-$80, a fraction of the cost of manufacturing a product that uses an SoM as a building block. That by itself is another incentive not to replace an SoM once it is embedded in a hardware product.
Where are Variscite customers coming from? How many are there?
In 2019, 39% of Variscite’s revenue came from Europe, 36% from the US, 15% from Asia and 5% from other parts of the world. Variscite has business relationships with 5,000 different customers from various industries, so the customer portfolio is highly diversified. There is no exposure to a single large client.
How big is the SoM market?
Estimates range between $1.5B to $3B annually, and we prefer to use a $2B estimate that indicates that Variscite has ~3% market share. The industry itself is quite fragmented, with several hundred small and medium-sized manufacturers worldwide. We are unaware of another public company that can serve as a comp.
It is also estimated that the market will grow 15% annually for the foreseeable future, with strong secular trends, such as IOT, serving as tail wind for this niche market growth. Variscite specifically has been growing 25% a year since inception in 2003, and in the last 5 years growth has accelerated to 30% annually. We note that Variscite has been growing twice as fast as its market and believe this trend will continue because Variscite has built a brand in a nonbranded industry. Variscite today is a highly respected operator in its industry.
We have spoken to several of its clients and learned that from a SoM client perspective, price is actually not the key factor in choosing an SoM supplier – the two key factors are credibility and support. If a client develops a hardware device with a 5-7 year life cycle, it is crucial that the SoM provider will stay in business. Variscite is an industry veteran, around for 17 years, making its contracts credible and compelling, and it also has strong professional customer technical support.
Management background and a recent change in investor relations
The Yagoda founding family and partners are controlling shareholders and own 43% of Telsys. Founder Thomas Yagoda serves as chairman of the board, and his son Amir is a “senior manager” while his son Assaf is a salesperson.
Salaries are reasonable and below what is customary in Israel for their positions. The ratio between the market value of Yagoda holdings in Telsys to their combined salaries is 117, and we think this implies an alignment of interest between them and passive minority investors.
Telsys bought parts of Variscite on four different occaisions since 2013, with the most recent purchase in December 2020. Currently, Telsys owns 70.8% of Variscite. Historically, Telsys was reluctant to engage investors, The main source for all business advancement maid by Variscite was a growing stream of dividends Telsys drew from Variscite evidenced in Telsys’s cash flow statements
In 2019, for the first time in several years, Telsys conducted an Investor Day. Management declared then, as well as on their Investor Day in September 2020, that a Nasdaq IPO is a company goal. Variscite’s CEO was introduced to the local capital markets for the first time during that September meeting. We believe there is a good chance this goal will be achieved in 2021. (The presentation (see link section below) is in English). We view it as a sign of management’s serious pursuit of a Nasdaq listing.
Operations and Financial Results
The following table summarizes Variscite’s key financial data from recent years:
- Sales have been growing at a CAGR of 29.4%.
- Operating leverage has a positive affect as operating margin improved from 33.4% to 45.6% (2018-2020 average was 41%).
- Management has estimated current FCF run rate at ~$23M annually, representing a 40% FCF margin.
- At the end of the first half of 2020 Variscite had ~$7.5M net cash on its balance sheet.
- Variscite’s manufacturing facility is in Kiryat Gat, Israel, an area that by Israeli law enjoys a special tax structure for manufacturers; therefore, Variscite’s regular corporate tax rate stands at only 7.5%.
- We value Telsys’s legacy distribution business based on working capital. Note that there is a degree of conservatism embedded in valuing the legacy business that way. We chose this way as the distribution has been in a rough patch the last two years. Yet there is a good chance management will be able to deliver strong results. For valuation purposes, the legacy business is worth 55 million NIS (17 million USD).
- This means that Variscite is valued at 18 times current FCF run rate.
- We also believe there is a remarkably high probability that the 30% growth rate seen in recent years will continue. We use the long term 25% growth rate that Variscite has displayed since inception and believe Variscite should double sales by 2024.
- Current FCF margin is at 40% (per management projections) and we believe it should improve. For valuation purposes, we use a constant 40% FCF margin.
- We use the current FCF multiple of 18 to assess terminal value as well as cash on the balance sheet, an estimation of FCF generated in H2 of 2020 and a recent use of cash to increase Telesy’s stake in Variscite.
- Based on the assumptions above, we believe Telsys is underpriced and with an intrinsic value of 244 NIS per share.
Key risks include:
- Geopolitical risk: A round of violence between Israel and its neighbors could result in difficulties shipping products out of Israel. Management has told us they have a back-up plan for such a contingency.
- Increased competition and low barriers to enter the niche: Skeptics say there is no I.P. that protects Variscite from new incumbents and therefore the niche is not a moat business. However, speaking to clients, we have concluded that Variscite has built a brand in what is essentially a brandless industry and therefore actually has a narrow moat. Additionally, the industry is maturing, and a new incumbent would need to endure several years of losses until reaching scale (Variscite was not profitable for the first 7 years of its operations).
- A move by chip manufacturers or PE into the SoM niche: In management’s 2020 talk with analysts, it was revealed that Intel tried to move into the niche and failed. We see that as a reason not to worry about manufacturers. We also believe that at the end of the day, $2B TAM in the SoM market is not lucrative enough for PE firms. However, if they were to move to the niche, they would probably choose to consolidate the industry, and an M&A spree in the SoM market would only be in Variscite’s favor. It would drive rising valuations for industry players, and Variscite would likely be one of the first niche companies that consolidators would try to acquire.
We believe Telsys is a compelling opportunity to invest in an under the radar, off the beaten path secular growth story. The Telsys-Variscite relationship displays strong profitability and produces enviable amounts of free cash flow, and we are unaware of any similar opportunities in the realm of growth companies. We have been shareholders for several years with high conviction, allocating more than 10% of our fund to this idea, and believe we will be shareholders for many more years to come.
Telsys web site
Variscite web site
Variscite’s 2020 investor deck (English)
Telsys page on the TASE
Anafa Capital is long Telsys (TLSY:IT)