Keysight Q3: Order recovery is encouraging (NYSE:KEYS)

I have Keysight Technologies (NYSE:KEY) stock in my previous article from July 2023 with a Strong Buy rating, highlighting the company’s potential to benefit from 5G and software solutions. The company released its Q3 Results on August 20^th. New orders growth appears to have bottomed out during the quarter. I estimate the company will return to positive revenue growth by fiscal 2025. I reiterate a Strong Buy rating with a one-year price target of $180 per share.

Order recovery despite weak end-market demand

As shown in the chart below, Keysight’s orders increased 0.4% year over year in the third quarter. It seems to me that order growth has already passed the bottom of the cycle.

The order growth is due to several factors:

• During the quarter, the Commercial Communications business unit reported low double-digit order growth. communicates via the Conference call on quarterly resultsthe traditional wireless business remains weak as telcos reduce their investments in traditional communications infrastructure. On the other hand, fixed-line order growth has been super strong, driven by AI investments from hyperscalers and data center operators. As explained in my launch report, Keysight’s measurement products are widely used in commercial communications and data centers, so it doesn’t surprise me to see their business benefit from rapid AI investments.
• As highlighted in the conversation, Keysight is investing in its own R&D resources for key applications such as GPU servers, AI workload emulation, and performance benchmarking. For example, Keysight has launched its AI data center test platform, which can emulate highly scaled AI workloads with high measurement accuracy.
• In the aerospace, defense and government sector, both revenue and orders declined year-over-year. Management attributed the weakness to the delay in U.S. budget passage. I believe the weakness is temporary as government spending is more likely to continue in the future. I expect business to recover in the coming quarters.

Growth in software and services

As discussed in my introductory report, Keysight has been expanding its software and services business to reduce the company’s earnings volatility. Currently, software and services account for about 39% of total revenue and are growing faster than the company’s overall growth.

On March 28, 2024, Keysight announced that it would acquire Spirent Communications for £1,158 million (US$1,463 million). Spirent is a global leader in automated test and assurance solutions for networking, cybersecurity and positioning. I think the deal fits well with Keysight’s acquisition strategy, and Spirent’s solutions and software can potentially enhance Keysight’s strength in the 5G, SD-WAN, cloud and autonomous vehicle markets. In my view, Spirent’s hardware and software solutions can be fully integrated with Keysight’s existing software and service solutions.

Outlook and assessment

Keysight expects revenue to decline by approximately 9.3% in fiscal 2024, as shown in the chart below. The forecast assumes a gradual recovery in the communications market in the second half of fiscal 2024 and fiscal 2025.

For growth in fiscal year 2024, I divide it into three major end markets:

• Aerospace, Defense and Government: As mentioned earlier, the market was weak in the third quarter due to the delay of government projects. As shown in the table below, the discretionary portion of the federal budget is expected to grow 4.5% in 2024. However, due to the delay, I expect segment revenue to grow 3% in fiscal 2024.

• Commercial Communications: I believe traditional telecom investments will face more structural challenges in the near future, but new growth areas such as data centers and AI will have a positive impact on Keysight. I expect Keysight’s commercial communications revenue to decline 5% in fiscal 2024.
• Electronic Industrial: I expect the weakness to continue in the coming quarters and segment revenue to decline by 20% in fiscal 2024.

Therefore, I expect Keysight’s total revenue to decline 8% in fiscal 2024. For growth from fiscal 2025 onwards, I expect end markets to gradually recover and Keysight’s growth to return to historical averages: aerospace, 5% growth in defense and government, 7% in commercial communications and 5% in electronics. So total organic growth is expected to be 6%.

I model an annual margin expansion of 20 basis points and make the following assumptions:

• 15 basis points gross profit margin improvement due to new product launches, mix towards software.
• 10 basis points of operating leverage from selling and administrative expenses
• As the company invests in AI technology, I expect the increased R&D investment to be a 5 basis point headwind to margin expansion.

With these parameters, the DCF summary looks like this:

The free cash flow from equity is calculated as follows:

The cost of equity is calculated at 13.6%, assuming: risk-free interest rate 3.8% ((US 10Y Treasury)); beta 1.4 (SA); equity risk premium 7%. With these assumptions, I calculate the one-year price target of Keysight stock to be $180 per share.

Key risks

During the conference call, several questions were asked about the weakness in the automotive market, particularly the electric vehicle market. Since Keysight provides test equipment for the automotive market, the company’s business will be affected by the weak demand. It seems as though management has no idea about the timing of the recovery of the broader automotive market.

Diploma

The recovery in order growth is quite encouraging and indicates a gradual recovery in end markets. I favor the company’s investments in AI and data center testing, as well as software and services. I reiterate a Strong Buy rating with a one-year price target of $180 per share.