Gemalto In A Bruising Transition Period

By | February 13, 2017

Summary

A steep decline in the SIM card business has drained the growth from this leader in digital security, and a slower EMV transition in the U.S. makes it even worse.

Securing and managing IoT devices and supporting the increasing security needs of enterprises and governments offer credible growth opportunities for the future.

Gemalto’s shares look a little undervalued today on the assumption of a high-single-digit FCF growth rate, but management has work to do to rebuild investor confidence.

It has been a while since I’ve written on Franco-Dutch digital security company Gemalto (OTCPK:GTOMY) (GTO.PA) (GTO.AS). I thought the shares looked interesting back in February of 2013 on the potential to benefit from growing 3G/4G adoption and the conversion to EMV chip cards, and the shares did alright in the following two years (albeit with volatility). Starting around mid-2015, though, circumstances changed dramatically for the worse in the company’s mobile SIM card business, and recent pressures from the payment/EMV business have made things worse.

I believe the company, and the shares, are in a tough transition period. I don’t think mobile SIM cards will ever be a driver for the business, and I’m not sold on the prospects for mobile payments and contactless EMV cards to drive meaningful long-term value. I do believe, though, that the company’s position in security platform/services, enterprise security, government, and machine-to-machine can drive worthwhile growth in the years to come.

The shares do look undervalued today on the basis of revenue growth in the neighborhood of 4-5% and FCF growth around 7-9%. That said, for those who can stomach the risk of missing out, waiting a little longer to make sure there isn’t another shoe to drop may be a better decision in terms of long-term risk/reward. In terms of the mechanics of buying the shares, the U.S. ADRs do trade, but there is better liquidity in the European markets and most brokers now handle these trades at reasonable prices.

Godzilla Hit SIMCity

When I last wrote about Gemalto, the company generated about 30% of its revenue from SIM cards for mobile phones (and an even larger portion of its earnings). Now SIM cards contribute less than 20% of revenue, and operating margins are lower. What’s more, it could get worse from here.

Some of the trouble in the SIM card business is simple business cycle maturation – companies like Gemalto and Oberthur are seeing more competition from Chinese rivals and pricing has come under pressure. There’s also something to be said for the slowdown in high-end smartphone sales. Volume has also been an issue, as registration requirements in markets in Africa and Latin America and in China have slowed demand.

Another big blow was the loss of the Softcard business when Alphabet (Google) (NASDAQ:GOOG) (NASDAQ:GOOGL) acquired this mobile payment joint venture and shut it down (with the IP integrated into Google Wallet). These SIM cards used in this venture were among the highest-ASP cards Gemalto sold, and the loss of this business had a disproportionate effect.

And it could still get worse from here. Although embedded SIM has yet to take off with phones, it could in the future. Gemalto would still be able to provide the software that network operators would need to activate and manage those eSIMs, but it is hard to say whether the margins would still work out in the company’s favor and whether the moat/ability to retain share from cycle to cycle would be as strong.

Gemalto has also had its challenges with a different technology, embedded secure elements (eSE). As the name says, these are secure elements embedded into the device (like a phone or watch) and can be used for securing mobile payments, granting access, and other similar functions. Oberthur staked out a big initial lead here (supposedly holding about 70% share in Android devices) and NXP (NASDAQ:NXPI) has done well initially with Apple (NASDAQ:AAPL). Gemalto has been making up for lost time here recently, but it still has some work to do to establish the sort of presence it’s enjoyed in SIMs.

Chip Cards Also Struggling Recently

The second big business for Gemalto, the chips used in the new EMV chip credit and debit cards, has also come upon harder times recently. Between large banks over-ordering, customer dissatisfaction with wait times, slower roll-outs from smaller banks/issuers, and further relaxation of the fraud liability (which reduces the incentive to drive the switch), this business has weakened noticeably in 2016 and recent comments from Oberthur and CPI Card (NASDAQ:PMTS) suggest it could be a while before the market returns to growth.

While the penetration rate for EMV in U.S. credit cards is pretty high already, there still could be some growth potential here for Gemalto. One of the primary objections to this transition has been the longer transaction times for the chip cards. Contactless cards are one way around that problem and they carry ASPs that are 30% to 100% higher for Gemalto. This could help reignite growth here, but I’m not counting on it.

IoT And Biometrics To The Rescue?

I don’t believe that traditional SIM cards will be a major growth driver in Gemalto’s future, and I’m skeptical about the impact of embedded SIMs and SEs, as well as contactless EMV cards. So where will Gemalto get its growth from? I think Internet of Things, enterprise, and government security can all help drive better results in the future.

Gemalto already generates about 10% of its revenue from machine-to-machine security, and the company offers an end-to-end solution that includes M2M modules, embedded SIMs, subscription management (On-Demand Connectivity) and an application enablement platform. I believe that securing machine networks is critical if IoT is going to have real relevance outside of limited applications like smart meters, as the risks of security breaches with connected cars and/or factories are significant. Gemalto is already well-placed in higher-end markets like autos, health, and home surveillance, and this business has been growing at a double-digit rate. If the more bullish predictions about industrial IoT prove accurate, this could become a very significant market for Gemalto, though there is the risk that chipmakers themselves step in and elbow Gemalto aside.

I also believe there are ongoing growth opportunities in enterprise and government products. Only about half of U.S. passports are equipped with advanced digital security enhancements and a far lower percentage of state-issued IDs currently have these capabilities. Given persistent worries about security, I don’t see this trend slowing, and the acquisition of 3M‘s (NYSE:MMM) identity business (including its second-place biometrics business) should allow Gemalto to offer better comprehensive solutions. On the enterprise side, data encryption, crypto management, and identity access and authentication remain significant issues and the acquisition of SafeNet back in 2014 helped the company round out its offerings.

The Opportunity

Back in November, Gemalto bowed to the obvious and slashed guidance for 2017 on the basis of weak trends in SIM cards, a reluctance on the part of network operators to invest in new platforms, and the slowdown in U.S. EMV migration. I say “obvious” because while Gemalto’s revision was a 23% cut from its prior guidance, it was only about 10% worse than where the Street already was, so clearly a lot of analysts already had significant doubts about the near-term outlook.

The delay in recognizing that 2017 targets weren’t achievable is only one example of Gemalto’s management looking flat-footed recently. The major declines in the SIM business seem to have taken the company by surprise and it was outbid by Oberthur’s parent (Advent) for Safran’s (OTCPK:SAFRY) Morpho, only then to turn around and pay a pretty high price for 3M’s Identity business. Given the greater potential synergies that Morpho would have offered (relative to 3M Identity), I worry that this was “penny wise, pound foolish”.

I would also note that the IoT market is still in the early days and still sorting itself out. While I think Gemalto can do well here, I can’t rule out the possibility that chip companies like NXP and Microchip (NASDAQ:MCHP) outmaneuver it with their own integrated security capabilities. I don’t believe the chip companies can or will offer everything that Gemalto does/can, but it could still be enough competition to blunt the advantages to Gemalto from widespread IoT adoption.

In terms of the financials, I expect Gemalto to generate long-term revenue growth in the area of 4% to 5%, with growth above that rate over the next three to five years as the company moves beyond the SIM erosion and the EMV transition challenges and sees better results from M2M, government, and enterprise customers. I also believe the company can and will drive FCF margins into the double digits over time, though fierce competition across the spectrum is going to be a challenge.

All of that leads me to believe that the stock might be 5% to 10% undervalued today. Every additional 1% of long-term revenue growth would add about $2/ADR or so to the fair value and an additional 1% of long-term FCF margin would add about $3/ADR.

The Bottom Line

I do have some concerns that the company could produce a lackluster fourth quarter and lower guidance again for 2017. Given that the shares aren’t dramatically undervalued, investors who can live with the risk of “missing out” may want to hold off and wait for another quarter or two of results before investing. I would note, though, that there’s a pretty wide range of opinion on this company (the highest sell-side price target I can find is about 60% above the lowest), so the odds seems good that a notably better/worse fourth-quarter report will drive a stronger move in the shares.

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Source: Seeking Alpha

 

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