My last two write-ups (FlatexDegiro and UMT) were relatively long and provided more depth than usual. This time I would like to go back to the original purpose of this blog, which is to present concise and easy write-ups, digestible for everybody. The blog is free (and will remain so) and it has no other purpose than to share interesting companies I’m looking at and to help me efficiently summarise the big picture without expanding too much into details. 

Fortunately today’s investment case is rather simple. The company is Cherry, a ~€180m small cap listed in Germany. Besides having a cool name (imo), Cherry has also some cool products; the company is mostly known for being the leading manufacturer of high-end mechanical switches for keyboards. With a market share of ~40%, Cherry is one of the most important players in this market and has been dominating it for decades. Other than producing and selling mechanical switches, over the years Cherry expanded into other hardware, such as keyboards, mice and headsets for applications in gaming & e-sports, and the office and healthcare sectors.

The company was founded in 1953 in the US, moved to Germany in the ‘60s and has been headquartered there ever since. Cherry went public in 2021, a year in which it broke all its financial records. Since then its earnings just went south, along with its share price; the shares listed at €32 and are currently trading around €7.50.

Cherry was growing quite nicely during the pre-Covid years, but business accelerated with the pandemic given the company’s direct exposure to gaming and WFH. But after the party came the hangover, which is what Cherry and its peers have been experiencing since. Keyboard manufacturers massively expanded inventories in order to meet the big surge in demand, but at some point demand was saturated and (keyboard) producers were left with massive inventory levels which now have to be reduced. The sector basically had a massive cycle in a very short period. If we combine the negative comps with a rise in interest rates, high inflation, a potential recession, China lockdowns, and a listing on a German stock exchange, we get where we are today.

As mentioned, the investment case here is relatively easy. Cherry is a high-quality company with good products, a great (niche) brand and strong market positioning, but inventory levels are still high and demand might be low(er) if we hit a recession. Nonetheless, notwithstanding short-term headwinds, the gaming industry and the (office) peripherals space have secular tailwinds, China seems to be reopening (Asia is a large and important market for Cherry), the balance sheet is strong (net cash position) and the valuation has strongly derated. Today we have a company at trough earnings, trading at an undemanding valuation and ready to snap back. The difficult period will pass and Cherry is strong enough to survive. Once the market stabilizes growth will come back, and both earnings and multiples will increase. Looking out a few years, Cherry might have multi-bagger potential.

But let’s first take a step back and look at Cherry in more detail. 

Cherry divides its business into two segments, Gaming and Professional, which are again divided into two sub-segments each. The Gaming segment consists of Components (high-end mechanical keyboard switches), and Devices (peripheral devices for gaming PCs). Professional is split in Peripherals and Digital Health and focuses on the production and sale of peripherals for office use and the healthcare sector.

Though perhaps not a household name, the Cherry brand is well-known in the sector and is considered to be one of the best (for mechanical switches, perhaps THE best) manufacturers of devices. The company has been leading in the design and production of mechanical switches for decades. Compared to low(er)-end membrane keyboards, mechanical keyboards (with mechanical switches) provide instant command responses, much higher durability and much more customisation potential. As such, mechanical keyboards are particularly important for the gaming industry. 

Cherry’s specs, designs and quality are considered to be among the best in the word. Part of the production is outsourced to selected partners in Germany, while the rest is produced in Cherry’s own facilities in China. This is also reflected in the company’s regional revenue split, with roughly half of revenue generation in Germany, ~40% in China and the rest in the US. Note that Cherry’s products and components are sold mostly via distributors; as such, this sales split mostly mirrors the location of the end-producers, but it is nonetheless a reflection of the importance of these end-markets.

One of Cherry’s main focus aeras today is growing its e-commerce activities, for which it is heavily investing. In addition, Cherry has historically been focussed on hardware, but is trying to grow its software business as well, mainly with the Digital Health segment. Nonetheless, the company’s main growth driver remains gaming (e-sports). 

Perhaps the best way to see how we got to today’s situation, is to look at Cherry’s history reflected in its financials, which I’ve presented below. I’ve highlighted in red a few remarkable recent results.

Over the period 2018-2020, Cherry’s growth was via the book: mid-teens revenue growth driven by Gaming (the largest segment), and steady increases in margins given operating leverage and the more rapid growth of Gaming (Gaming historically had mid-30s ebitda margins compared to high-teens/low-20s for Professional). Then came the covid pandemic, which massively distorted end-markets. While Gaming continued to grow, the Professional segment exploded. And in line with the rest of the sector, Cherry invested heavily in growth, which is reflected by the higher opex in 2021 (incl. ~€6.5m IPO related costs) and negative cash flow (incl. some capitalised R&D).

However, as previously mentioned, the music stopped in 2022. Though the Professional segment has been resilient throughout last year (mainly attributed to a ‘sticky’ step-up in WFH penetration and the roll-out of eHealth terminals in Germany), Gaming on the other hand was obliterated due to the China lock-downs. Supply chain disruptions, inflation and the ongoing investment programs for growth (mainly e-commerce) have crushed margins, as can be seen from the 9M22 results. 

The outlook might continue to remain bleak over the short-term. The company is investing heavily to expand its e-commerce activities and modernise its product portfolio, and it would be detrimental to business to trim these programs down. In addition, Corsair and Logitech recently mentioned improving inventory levels, but they remain at historically high levels. Nonetheless, I believe that the current situation might provide an attractive entry point or at least warrants Cherry to be a top-position on the watchlist. A small-cap with a strong brand and solid tailwinds, currently at trough earnings and low multiples is not something you find every day. It might still be a bit early, but once comps improve, inventory is cleared and growth returns, earnings could snap back quickly, along with Cherry’s valuation.

To get a feeling about the potential, I made some back-of-the-envelope estimates. As always, keep in mind these are very high-level and you should make your own assessment.

In short, I believe the potential here is mainly due to Cherry’s Gaming revenues somewhat snapping back to normal. As China reopens, supply chain disruptions ease and inventory is traded down, Gaming revenues should return to the normal, long-term trend driven by all the well-known tailwinds. In my guesstimates above I’m assuming a normalisation of Components revenue in 2023 and a snap back in 2024. No idea if that happens, but my 2025 estimates are in line with 2019; this is pretty conservative imo. Furthermore, I’ve kept Professional fairly steady; Cherry’s e-commerce strategy is promising and I’m giving them no credit for that. In addition, this segment should see an increased focus on software revenues, mainly in Digital Health.

Overall, I believe my forecasts three years out are relatively conservative. Results might be lumpy and will definitely be different than what I’m modelling here, but I’m basically assuming that life will return to normal between 2023 and 2024 and that Cherry’s revenues will reflect that. Also, the company is investing for growth at the moment, and these programs will provide a return at some point; nonetheless, I’m giving Cherry here little in terms on margin expansion (2025e is in line with 2019). Based on these estimates, Cherry is trading at ~4x my 2024 ebitda estimate. And for you Gordon-growth fans out there, c. 50% free cash flow conversion (in line with 2018-2020), 3% steady state growth and a 10% discount rate results in roughly €240m equity value today (based on ~€17m free cash flow in 2024 and €30m net cash). This basically means that at the current valuation, we do not pay anything for >3% growth as of 2024 and we still get a 25% discount on the equity.

Cherry has a net cash position, which it is using to weather this difficult period, do bolt-on acquisitions and buy back shares. In addition, Cherry has a relatively good level of transparency. Compared to other European small-caps, Cherry reports quarterly and disclosures include the balance sheet and cash flow statements as well – in English. This might seem logical to many, but I guarantee you that this level of transparency is far above normal for European (German) small-caps.

To conclude, a risk here is clearly timing. The company’s products are high-quality and its positioning in the market is strong, but that does not mean that the share price could not derate further. Just a couple of months ago Cherry shares were trading at ~€5.50, about 25% lower than today. Cherry’s clients are still facing high levels of inventory and a recession will just extend the current tough environment. The market is clearly aware of this and is undoubtedly pricing this (partly) in, but not 100%. Again, if a recession would materialise, Cherry shares will definitely drop. Nonetheless, at roughly 4x 2024 ebitda on relatively conservative estimates, this company warrants at least a (top) position in my watchlist.