Reflections on Pace Micro Technology Plc

Since the start of this year, Pace Micro Technology (LON:PIC) is down about 35%. I actually remember the company appearing on value screens some time in mid-2010 and with this latest dramatic decline it is popping back up again. I can’t remember why I didn’t get involved last time but this obviously makes me cautious. I believe the dramatic declines we are seeing now are probably a function of two technical factors (as well as more fundamental factors I will look at in the main body of this post): first, the company used to be a growth stock. In 2009, it put in a good performance shedding the stigma attached with its dismal performance in mid-2000s/tech blow-up. To me, this potentially means we are going to see dislocations as ownership changes from growth to value investors. Second, the company wasn’t as open with customer order delays as it could be (here). To most investors (and me), this was a massive red-flag which potentially makes the company uninvestable at almost any price. These are obviously quite intangible and unique factors but I think they are worth mentioning, outside of the normal factors, as I think they will play a significant role going forward. 

As usual, I will first deal with quantitative factors. From the above we may see some signs that PIC isn’t the “usual” value candidate. First, its operations have been very volatile. Indeed, these figures may mask it slightly. Revenue in 2005 was only £178m, net profit in 2006 was only £6m and the company lost £28m in 2005. What this means is that we have to be very careful in valuation. Past results are likely to be very different from future results and there is considerable ambiguity over true operating results as turnarounds are always accompanied by more non-operating/extraordinary items. In particular, I would highlight my treatment of impairment as inconsistent as PIC has a habit of charging it in a different place every time (i.e pre-tax/after tax/pre-finance expense). Second, the company made a big acquisition of 2Wire in 2010 for around £280m, net of cash (details of acquisition: circular and presentation). This was financed with debt and apart from these balance sheet effects, I believe it represents a change in business model. Either way, we find that PIC’s past results aren’t going to be very helpful going forward.

From the above graph, we can see the volatility in operations but what we also see is that PIC is a low-margin business (Its major competitors are Technicolor and Motorola Mobility) and its operating results really depend on its sales performance. In 2008 and 2009, sales growth was clearly strong with reports citing big contract wins (Comcast and Net Servicos in Brazil) and presumably, the switch to HD/3D. What we notice though is that sales are pretty volatile. ROCE has tended to be slightly lower than RNOA as the company has usually run pretty high cash balances however, this has changed with the increase in debt as a result of 2Wire. The company has a consistently negative cash cycle, however, it has been pretty volatile as the way the company uses inventory is changing as it is holding more finished products. Cash flows have been equally difficult to work out. Accruals are massive with cash flow before WC changes of well over £100m in the past two years (net was £40m in 2010). This discrepancy appears to arise from “development expenditure”. This is amortized heavily and so added back to cash flows whilst the expense is classified as investing. I don’t really think anything that exciting is going on with this but I am not really familiar with this accounting as I see R&D is also expensed in the income statement. So although the massive acquisition of debt has played a role in significantly changing the balance sheet, valuation appears pretty reasonable. However, this relies on the acquisition being worth the price.

Looking at the circular, I can say straight away that I don’t think this is right. To be blunt, the company overpaid however, looking past this there are interesting factors to discuss and maybe a reason why I could be wrong. First, this acquisition represents an important change in the right direction. Pace mainly just sold set-top boxes i.e Sky boxes. However, the industry is clearly moving towards a consolidation of the provision of services. The best example of this is Sky, before they just use to do TVs but they worked out you can use the same technology, roughly, providing phone and broadband services as well. Therefore, they can provide this package of services cheaper than the household going to a phone provider, a broadband provider and a TV provider. We are also seeing the need for technology that builds on this new provision of services, for example, allowing you to surf the internet on your TV and more importantly, download/view content. 2Wire provides this hardware and software for these so-called “residential gateways”. Previously, 2Wire was owned by a consortium of telco companies, most importantly AT&T. This is the biggest strength in the acquisition as this business was perhaps peripheral to what the telco companies were doing but AT&T provides around 60% of 2Wire’s revenues. However, this misses out one obvious point: competition. These changes in the industry have led to cutthroat competition with companies like Sky and BT suddenly becoming competitors. One way to view this is that PIC are merely providing the weapons for the battle and so will profit regardless. To some extent, this must be true however, competition in providing these weapons will be unquestionably fierce. One possible outcome is the acquisition of a manufacturer by a provider as in Amstrad and Sky. As suggested by the 2Wire sale and Sky’s acquisition, these have been unsuccessful so we would expect providers will stay out of manufacturing. So the acquisition is unquestionably a good one for the continued survival of PIC and there are clear synergies for selling 2Wire’s products to its usual set-top customers. However, the business it is moving into is just as competitive as the last and although the relationship with AT&T is favourable the price doesn’t allow that much margin for these risks.

On top of this, we have the more general factors which resulted in the chaotic reaction to the latest interim statement (here). The most important is the continued poor performance in Europe which has been linked to the acquisition of Phillips Europe’s set-top box business. However, this appears to be largely a margin issue as the company highlights that they have met their revenue/volume targets across the board. To me, this seems extremely encouraging as margin issues are usually a short-term issue although, caution would be suggested as margins have held up at both of PIC’s competitors. The best case scenario would be that it is a function of the Japanese earthquake however, FY10 results for Europe were also very weak suggesting something else is playing a role. Certainly, we get the impression from reading the reports that PIC dominates in the US, South America and  parts of Asia but it has more trouble in Europe.

The story with PIC is therefore, pretty complex. The company is in an industry going through major transitions of competitive advantage and the company’s financial statements are certainly no longer representative of the situation going forward. In addition, there are questions over the company’s control over internal reporting. I hope to have provided at least a basic outline of the condition of the industry but there are still too many questions. I can see how this could be a good buy as current results suggests the valuation is good and the growth prospects are there however, I really don’t have enough information to asses these prospects. Either way, it will be interesting to see how PIC’s operations develop (especially as I am looking at one of its customer, Net Servicos).