January 16, 2009 - 9:48am EST by
2009 2010
Price: 19.37 EPS $2.41 $1.63
Shares Out. (in M): 59 P/E 8.0x 11.9x
Market Cap (in $M): 1,137 P/FCF 6.4x 11.9x
Net Debt (in $M): 205 EBIT 239 146
TEV ($): 1,342 TEV/EBIT 5.6x 9.2x

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In HAR the market's current extreme short-term focus has handed us a potential five-bagger. HAR is primarily a maker of infotainment and audio systems for luxury cars. As such, the macro-economic headwinds are obvious. In addition, HAR's results have suffered from bad management as the complexities of launching an unprecedented number of new platforms led to significant, but avoidable, cost overruns. The good news is that the previous leadership has been replaced by a super star CEO, who has filled out the ranks with a strong turnaround team. Unlike most auto parts makers, HAR is fundamentally a very good business with lasting competitive advantages and we believe the new CEO has a shot at delivering on his stated plan to add $400m in operating profit to an adjusted F08 base of $239m through restructuring initiatives. This implies a target operating margin of 15.5% on normal (fiscal year ended June 2008) revenues. Consensus is looking for a 4% operating margin in F09 as well as depressed volumes, which translates into EPS of $1.63. At 11.9x F09 consensus earnings and with net debt at less than 1x forward EBITDA, the market is arguably assigning a zero probability of success to any of the restructuring initiatives. The valuation also implies depressed volumes into perpetuity. While we think the auto industry downturn will be worse than currently contemplated in consensus numbers, over a time horizon longer than one to two years, the margin recovery will be a much larger driver of EPS than the volume weakness. There is clearly near-term risk, but given the magnitude of the upside, it could be foolish to wait for better end market visibility before taking advantage of the current valuation.

HAR has three segments. The largest and most important is the Automotive segment, which in F08 contributed 72% of revenues and $189m in adjusted segment profit out total adjusted segment profit of $288m (before corporate costs of $49m, restructuring charges of $43m and unusual warranty costs of $40m). In this segment, HAR supplies infotainment systems to luxury car makers such as Mercedes-Benz, BMW, Audi, Porsche and others. HAR has a dominant position in this market with share of over 50% and in many cases (including Audi and BMW outside of Asia) HAR is the sole source supplier. More than half the value-add is in the software and there are scale advantages in R&D. R&D constitutes roughly 10% of HAR's revenues and with rapid technological progress, this makes it difficult for smaller competitors such as Alpine to offer competing systems profitably. In fact, even competitors' systems are based on HAR's operating system QNX, which is the de facto standard in the luxury segment. QNX is a compartmentalized operating system, in which a single component's temporary failure doesn't lead to the entire system's crash. This makes it much more stable than, say, Windows. This is crucial in cars and in the many other environments in which QNX is also used, including Wynn Casinos, Cisco routers and NASA. According to management, even Russian submarines use QNX, though illegally (I will not attempt to confirm). Infotainment systems are one of the most important product differentiators for luxury cars and with significant product innovation, HAR has pricing power with the OEMs. As we have learned in conversations with OEM purchasing managers, the OEMs do not manage HAR to a certain margin target and any cost savings are generally HAR's to keep. This is obviously very different from the auto parts industry in general. Customers enter into five to seven year platform-specific contracts (i.e. for the life of the platform) with set pricing and minimal annual price declines. End market demand aside, this leads to great revenue visibility. The market for infotainment systems is still growing nicely on a secular basis, as attach rates grow, infotainment systems continue to penetrate the car market further from the luxury segment down and electronics in general (DriveAssist, etc) become a larger part of the value of an automobile.

While approximately ¾ of the Automotive segment consists of infotainment systems, the remainder consists of premium audio systems also sold to luxury car OEMs. HAR owns the strongest brands in the business incl. Harman/Kardon, Mark Levinson, Infinity and JBL and as in infotainment systems, it has a very strong market position (though in this business it's based more on the consumer brand than technological advantages). Consumers often associate a certain audio brand with a certain car maker, a phenomenon that is reinforced by audio brands being featured in OEM advertising. This makes it hard for OEMs to switch and provides HAR with margins that are unheard of in other parts of the auto parts industry (10+% operating margin, according to industry participants). HAR's Automotive segment overall had a mid-teens operating margin before the launch-related cost overruns began in the middle of F07.

HAR's other two operating systems are Professional (15% of F08 sales) and Consumer (13%). The Professional segment makes complex integrated audio systems used in a wide variety of settings including stadiums such as the Bird's Nest in Beijing, airports, houses of worship, concert tours, radio and broadcast, recording studios, cinemas etc. HAR is far and away the biggest player in this very fragmented market with approximately a 1/3 market share in many of the applications listed above. As you can imagine, customers have a low tolerance for failure of these increasingly complex systems, so HAR's brands and research capabilities are very important. The Professional segment has a history of stable and growing margins (16.0% excl. restructuring in F08).

The Consumer business includes consumer audio (home audio systems) sold under the Harman/Kardon, Infinity, JBL and other brands and some portable navigation devices. Profitability in this segment has cratered to zero in F08 as the PND market has become much more competitive and niche players like HAR could not compete. While Consumer likely includes some profitable components and HAR is trimming and refocusing the segment to return it to profitability, we're conservatively assigning no value to this segment.

HAR's new CEO Dinesh Paliwal joined HAR in July 2007 in conjunction with the planned KKR LBO at $120 per share. HAR's prior CEO was weak and did not have the stature to implement the required operational changes while serving under Chairman / Founder Sidney Harman. Sidney provided the vision for HAR's automotive expansion, but at 88 years of age, he might have lacked the perspective to transition the business from a smaller entrepreneurial company into a larger, more centralized and more efficient corporation. The LBO later fell through as the debt markets froze and HAR's profits fell short due to the cost overruns.

Dinesh previously led a much larger and more complex key business at ABB to profitability following many years of losses. KKR tried very hard to get Dinesh on board, in fact Henry Kravis personally had dinner with Dinesh three times to convince him to join despite HAR being a much smaller company than ABB. Dinesh has gradually replaced much of the senior leadership of the company (including Sidney Harman's daughter) with many of his former ABB colleagues. This process continued even as HAR's stock sold off, a testament to Dinesh's former lieutenants' belief in both Dinesh and in HAR. During 2008, Dinesh also replaced Sidney as Chairman, so he has effectively been given a free reign. Dinesh has invested a large portion of his net worth in HAR and most recently bought approx. $0.6m worth of stock on 9/9/08 at around $33. We have met with Dinesh and CFO Herbert Parker and were impressed, though to date investor communication for HAR in general has been fairly ineffective and appears to have been somewhat of an afterthought.

Turnaround plan
Dinesh initially focused on ensuring on-time platform launches. Missing deadlines can be a death sentence in this business, as it would hold up the OEM's entire platform launch. HAR is the only infotainment maker that has never missed a launch. Competitor Bosch botched a launch recently and as a consequence is expected to be forced to exit this business. HAR has now successfully launched over half the 13 platforms scheduled for F08 and F09 (compared to 2 platforms in F05, zero in F06 and 2 in F07), though at a cost. HAR had to hire many expensive temp engineers and existing engineers weren't available to manage costs lower, as had previously been the case. This has caused the adjusted Automotive margin to drop to 6.4% in F08 (adjusted for restructuring and the unusual warranty expense of $40m), even before end market cyclicality could be felt in earnest. Prior to this, the Automotive segment had a mid-teens operating margin for many years.

In F08, management has also gone to work on a turnaround plan, which the company first discussed in February 2008. In the current form of the plan, HAR is targeting $400m in EBIT improvements off of the adjusted F08 base of $239m by fiscal 2011, with $55m in improvements targeted in F09, another $210m in F10 and the remaining $135m in F11. On F08 revenues, this would imply an operating margin of 15.5%, up from 5.8% in F08. 15.5% might or might not be an aggressive target, but clearly even a fraction of the targeted savings would make HAR a very attractive investment. Dinesh himself considers the target conservative. The plan is based on flat volumes (to prevent executives from taking credit for volume growth related EBIT improvements), so in F09 some or all of the improvement is likely offset by cyclically weaker volumes and in the out years, there could be upside by the same logic.

The restructuring program makes sense to us and consists of cost savings and productivity initiatives in manufacturing (approx. 45% of total), sourcing and engineering (approx. 20% each) and SG&A (approx 15%). They include the shifting of operations from Germany and other high-cost countries to lower cost countries such as India, the outsourcing of non-proprietary off-the-shelf technology and the standardization of products and software code across platforms to increase economies of scale. We have spoken to sourcing executives at some of HAR's most important customers: they were comfortable that the initiatives would not hurt HAR's ability to innovate and to deliver high-quality on-time product. They also added that HAR should have taken these steps a long time ago (as the OEMs themselves have).

With an adjusted F08 EBIT base of $239m and $400m in targeted cost savings, F11 EBIT would be $639m. With a market cap of $1,137m, net debt of $205m and EV of $1,342m, HAR trades at 2.1x this EBIT estimate. With a 29% tax rate, $13m in interest and other expense, $1m in minority interest add-backs and 58.7m diluted shares, F11 EPS would be $7.55. If HAR traded at 12.5x forward earnings in one and a half years (i.e. mid 2010), the stock would be at $94, up almost five-fold. The above estimates are before reflecting the use of interim FCF or any changes in volumes from F08 levels.

The most obvious risk is near and medium term end market weakness in HAR's automotive business. Unit sales for HAR's most important OEM customers Mercedes-Benz (MB brand only), BMW (excl. MINI) and Audi declined by a weighted average of 2% year over year in the SepQ08 and 12% in the DecQ08. To date, the German car makers haven't been as affected by the global economy as the US car makers, as the German car makers' balance sheets are in better shape (allowing them to continue to finance consumers and dealers). Also German and French consumers have not embarked on a debt-financed consumption binge in this decade. To the contrary, Europe luxury car sales have yet to return to 1999 levels and the age of the fleet is quite high. Germany and France constitute about 40% of sales for the German OEMs.

Still, it could get worse. One near-term downside scenario could take the following into account: 1) some further macro-weakness, 2) the headwind from the MB E-Class going dual sourced in F09 (a decision MB made a few years ago and has since tried to reverse), 3) adverse currency effects, and 4) a partial offset from continued growth from platform launches and increases in attachment rates. In my estimate, this would translate into a roughly 20% revenue decline (approx. $800m). Assuming a 25% contribution margin we would have a $200m cyclical EBIT hit relative to last year's $239m base. Giving them credit for $55m in savings as per the F11 plan and another $50m to reflect temporary cost initiatives the company is pursuing in light of the environment, this would get us $1.60 in EPS. Coincidentally this is very close to consensus, which is probably too slow to adjust the revenue outlook but doesn't give credit for the savings. Could it be worse than $1.60? Clearly. However as mentioned before, the medium term margin upside could make waiting for a bottom in auto volumes a mistake. In addition, HAR is clearly a unique and attractive asset and there is risk of a hostile take-over bid given the current valuation. At the auction process preceding the KKR deal, there were a total of 20 interested parties classified as "strategic".




Margin / restructuring progress


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