Sunday, May 21, 2006

Harman International- An Auto Parts Growth Story

Harman International (HAR) is a worldwide leader in audio, electronics, and "infotainment" with such brand names as JBL, Infinity, Harmon/Kardon, Mark Levinson, and Becker. The company is a worldwide leader in the markets it serves including Automotive, Consumer, and Professional segments. This is much more than an auto parts story, but automotive, representing 70% of sales versus only 62% three years ago, is dominant.

Automotive sells to DaimlerChrysler, the BMW Group, Toyota, Audi, Porsche, Land Rover, Renault, Hyundai, Kia, the PSA Group, and Volvo. Infotainment systems may include voice-activated telephone and climate controls, navigation, rear seat entertainment, Internet access, hard disk recording, MP3 playback and Windows Media Audio playback. Automotive sales in the most recent quarter have grown by 8.6% but ex-currency by 16%. Operating margins, despite dealing in the very competitive automotive segment are a healthy 16%.

Dave Leiker, an old friend at Robert Baird, in TWST last year, described Harman as one of the few growth stories in automotive parts. Why? Less than 10% of HAR's business comes from GM, Ford, and Chrysler. To quote TWST, " It’s primarily the German automakers, where they’ve developed a very sophisticated infotainment system using a fiber-optic network and digital technology. This consolidates multiple devices, such as radio, climate control, CD, DVD and cellphone into a common unit with a single user interface. Today, they effectively have 100% of the German auto market."

Consumer Systems, sells through speciallty stores and chains such as Circuit City and Best Buy as well as MediaMarkt in Eurioe. Products include Multimedia that is  geared to enhanced sound for AppleiPods and MP3 players as well as home audio and video systems. Consumer operating income was $5.2 million representing a fairly slim 4.9% operating margin.. Consumer operating income was 27% lower than a year ago, primarily due to 2.1 million of increased investments in R&D for new multimedia products and the acquisition of PhatNoise. The company expects that operating margin in this area can improve to a 9% level within a few quarters.

The professional segment designs, manufactures and markets loudspeakers and electronics for audio professionals in concert halls staiums, and broadcast applications. The company is a world leader in professional applications. Operating profits in this segment have grown 35% yoy and currently represent about 11% margins at the operating level.

The company has won $1.5 billion in new business over the last year as a technical and R&D market leader. R&D spending in the third quarter was about 9.2% of sales, versus 6.9% of sales in the prior year. R&D spending increased in each of the three operating groups with the largest increase in automotive.

More than 60% of HAR's sales and operating profits come from outside the U.S. and consequently foreign currency effects are significant.

The company has excellent visibility of the future from the automotive segment with a backlog of $13 billion out to 2013. The premium branded audio systems are quite ubiquitous optimizing acoustic performance and minimizing space and weight requirements. Infinity branded car audio systems are offered by DaimlerChrysler's Chrysler Division, Dodge and Jeep lines as well as by Mitsubishi and Hyundai/Kia (in North America). DaimlerChrysler's Mercedes−Benz Division, the BMW Group, Land Rover, Porsche and Saab provide Harman/Kardon branded audio systems in their cars. The premium Mark Levinson system is offered by Lexus. Rolls Royce vehicles come standard with a Lexicon branded audio system. Toyota, the PSA Group and Hyundai/Kia (in Korea) offer JBL branded audio systems. HAR provides infotainment systems in Mercedes-Benz, Porsche, Audi, Renaul, and Land Rover. There appears to be unprecedented consumer demand for information and entertainment in the car.

The company has proven to be a good partner to its shareholders. It has reported options as an expense since 2003, not kicking and screaming like most companies that were required to implement options expensing this year. The company's CFFO continuously has exceeded reported earnings with CFFO for the last five years totalling $1.4 billion versus net income reported for that period of $586 million. Harman's capex for the last five years has been sginificant too at $655 million.The company has bought back about $223 million net of issuance in the last five years as well. In the current fiscal year (June year) the company has accelerated its buyback with the purchase of $116 million in stock. The dividend is negligible representing a payout ratio of less than 1%.

The stock price is down about 16% YTD and is selling at an EV/EBIT of about 13.8 times. Enterprise value is about $5.44 billion reflecting only about $330 million in long term debt offset by about $400 million in cash. Return on invested capital is about 18% for the last twelve months and has significantly improved over the last five years from the mid-single digit level.

The operating return on assets for the automotive segment is in the mid-20's an extraordinary level for what might be thought of as an extended auto-parts business.

Clearly, this is a global competitor and a leader that does not appear to be very well known to most retail investors. The 8 Wall Street analysts that cover have growth expectations of 18-25% with the consensus at 21.75%. Even with a much more modest 15% growth rate that I am using and overall operating margins at 11%, I can come up with a value much closer to $130 for HAR  compared to its current $82.35, just four dollars above its 52-week low.

Disclaimer: Neither I, my family, nor my clients have a current position in Harman International.


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