Value Investors Club / BELDEN INC (BDC)

Description

BDC Initiation

Thesis

 Attractive valuation (13.7x forward EPS, 10.6x EV/EBITDA)

 High and sustained ROE’s and ROIC’s (~25% and ~14%)

 Improving & sustainable operating margin expansion (14% going to 20%)

 Intelligent capital allocation. Belden is a capital compounder along the lines of

DHR and APH, yet it still trades more in line with commodity cabling companies.

 Underappreciated/underfollowed with only 7 sell side analysts actively

publishing, all at 3rdtier shops.

 Between MSD organic growth, substantial margin expansion, value added

acquisitions, and buybacks, EPS should be able to grow mid-high teens

sustainably. This should lead to a re-rating of shares away from the commodity

cabling companies and towards capital compounders like APH and DHR.

Barriers to Entry and Competitive Moats

Belden operates in 4 business segments, and the acquisition of Tripwire is adding a 5th

10 years ago, when current CEO John Stroup came on board, approximately 90% of the

business consisted of largely commodity cabling components. Today, that figure is down

to less than 30%, with the remainder made up of differentiated broadcast, connector,

networking, and security solutions.

Belden has by far and away the #1 market share in its broadcast solutions space. They

have made a series of acquisitions in order to roll up end to end coverage of everything

from the camera connection, through networking and connectivity, monitoring & editing,

and more. This business has above corporate average profitability, requires little capital,

and is forecast to grow 5-7% in the medium term.

Enterprise connectivity and industrial connectivity are the two lowest margin and lowest

growth businesses for Belden, comprising about 45% of sales. About 2/3 of this group,

or 30% of total revenues, are lower margin cabling assets. 1/3 of this group is more

differentiated, higher margin networking and connectivity assets, and the business is

definitely mixing in this direction. Overall, the connectivity group is basically the cash

cow for the company.

The industrial IT group is small, but it is growing very quickly, very profitable, and

consists of highly differentiated assets mainly in industrial networking and connectivity.

Finally, Belden acquired Tripwire in January of this year. While ostensibly a big

departure from their traditional businesses, the bet on Trip is that Belden’s industrial and

broadcast customers have not secured their endpoints, and as they increasingly connect

their capital equipment to their networks they will require additional layers of security.

Belden will be able to cross sell endpoint security along with its connectivity and

networking gear. Admittedly this acquisition is further afield than most had expected to

see from Belden, but the two companies had been co-selling for over a year before the

deal was announced (meaning that they wouldn’t have acquired Trip if their partnership

hadn’t demonstrated success beforehand) and so far it is tracking ahead of expectations.

The net takeaway here is that Belden used to be a company with little barriers to entry

and no competitive moat, but now it has transformed itself into a highly differentiated

business with dominant competitive positions, high barriers to entry, much improved

profitability and returns, and far better growth. In spite of these changes, the stock is

still being valued as if it is still a commodity company, inline with much lower quality

companies like General Cable.

Margins and Cash Flows

Operating margins have already expanded from 9% in 2010 up to 14% in 2014, and

management has laid out a medium term target calling for continued expansion to the 16-

18% range. However, with the addition of a software company like Tripwire, continued

mix shifts away from commodity offerings and towards differentiated solutions, and

further efficiency gains I think a 20% operating margin target is a real possibility further

on down the road. Operating margin expansion stories are a real source of alpha in tech,

and if Belden can in fact expand margins at a clip of 100bps per year going forward I

think it is likely the stock outperforms by a good margin.

Returns on invested capital have been pretty stable at around 14% annually for a number

of years. Management runs the business for ROIC over time, and they have a strong

capital allocation discipline where they are focused on the highest ROIC projects

available, whether that’s organic investment, acquisitions, buybacks etc. I would

anticipate that ROIC will trend upwards along with operating margins over time. The

company targets a 13-15% ROIC on acquisitions within a 3 year time frame. They have

also retired 10% of the float over the last 4 years. Net debt to ebitda will exit ’15 at 3.4x,

and hit management’s target of 3x through ebitda growth aloneexiting ’16.

Management also believes FCF’s are the lifeblood of the organization, and they have a

strong net income to FCF conversion ratio. Margin expansion in conjunction with its

FCF/ROIC framework will continue to enable Belden to become a capital compounder

along the lines of DHR or APH over time.

Management Team & Incentives

CEO John Stroup is a critical component of the BDC story. Stroup started his career

learning lean manufacturing at Toyota. He has implemented these practices at Belden’s

various manufacturing facilities and greatly improved margins at even the company’s

more commodity like operations. Stroup also spent several years at Danaher where he

started at VP of Business Development and eventually assumed the role of President of

the Motion Systems group. Danaher is obviously one of the most successful

compounders over the last 30 years, and if he can replicate even a small portion of

Danaher’s M&A success at Belden we’ll be in good shape. He has now been at Belden

for nearly 10 years and his efforts to transform the company from commodity cabling

(90% of the business when he took over, < 30% today) to differentiated, higher margin

solutions is nearly complete. That said, the company advertises the fact that they have a

funnel with over 1000 potential acquisition targets so he has plenty of runway to continue

on this strategy.

Management only owns 1% of shares outstanding. That said, their compensation plan is

designed with shareholders in mind. The primary four factors according to the proxy are

operating margins, organic revenue growth, FCF, and ROIC.

Current Events

The Tripwire acquisition is the most controversial aspect of the Belden story today. First

of all, Trip is an enterprise security company, not an industrial connectivity company.

Second of all, Trip is on pace to achieve management’s targeted 13-15% ROIC within 4-

5 years post acquisition, which is longer than the typical 3 year period of time. So it does

appear that strategic as well as financial risks are higher than average with this deal. On

the other hand, Trip has been a steady 15% grower for several years, as opposed to most

of Belden’s acquired businesses which grow in the mid single digits organically.

Additionally, the potential for cross selling is much greater for this deal. Security

solutions are increasingly required at the endpoints in the industrial and broadcast space

(as opposed to just at the network edge) as machines are being connected up to enterprise

networks a la the “internet of things”. This is a huge new opportunity for Trip, but they

haven’t had the distribution to sell into these end markets. Now as part of Belden they

will be able to capitalize on this opportunity over the next 2-3 years.

Long Term Outlook

Even with a top line organic growth rate in the mid single digits, I still think BDC will be

able to compound EPS in the mid-high teens for several years. Operating margins have

already expanded from 9% in 2010 up to 14% in 2014, and management has laid out a

medium term target calling for continued expansion to the 16-18% range. However, with

the addition of a software company like Tripwire, continued mix shifts away from

commodity offerings and towards differentiated solutions, and further efficiency gains I

think a 20% operating margin target is a real possibility further on down the road. In

addition, further de-levering and continued reductions in shares outstanding can push

EPS growth up into the teens through at least 2017/18. This is one of the few technology

companies that has a strong understanding of capital allocation, and compounding actions

will be working for us at Belden, as opposed to against us through stock dilution and

value destroying acquisitions at many other tech companies. Longer term management

aspires to have the financial characteristics of APH, which is essentially the equivalent of

the Berkshire Hathaway of technology – and if Belden can continue pushing in that

direction I think it will be a good stock for us.

Valuation

BDC shares are trading at 13.7x cy16 EPS, 10.6x EV/EBITDA. Other capital

compounders like DHR and APH trade more in the 18-21x range. Considering BDC is

earlier in its transition it is reasonable to expect a discount vs. best in class companies –

but if BDC is able to pull off the transition and expand its margins the way I expect then

the upside will be substantially greater. I believe at this point that the street’s perception

of BDC is still anchored to their historical commodity cabling business, but with

continued execution over the next 1-2 years commodity businesses will represent only

20-25% of sales and BDC shares will be poised for multiple expansion. A reasonable

upside target over the next year could be $104, or 17x ’16 EPS, for 23% upside.

Recommendation

BDC shares are the appropriate market cap for Smid or Mid. I would begin accumulating

a position < $85, and if shares were to crack $80 I would get very aggressive.

Risks & Mitigating Factors

 Leverage: the company sports 3.4x net debt to ebitda, which is a pretty high

degree of leverage for a tech company.

 Valuation: shares are cheap on PE (13.8x), but not quite as cheap on ev/ebitda

(10.6x) or FCF yield (5.8%).

 Competition: Belden’s core cabling business experiences lots of competition,

including on pricing. Broadcast has lots of competition but Belden has top market

share. Tripwire definitely has competition, although less so in the industrial

space.

 Organic growth is modest in the mid single digits. If this slows at all FCF

generation might not be enough to fund further acquisitions to the extent I expect.

 The Tripwire acquisition is more expensive (paid 13.4x ebitda), more risky

(security is outside of Belden’s core competency), requires a longer period of time

to hit ROIC targets, and depends more on riskier revenue synergies than previous

acquisitions. If one thing goes horribly wrong with my thesis it would likely be

Tripwire.

 Belden reported a disappointing Q1 and the stock traded off. This provides a

better entry point for us, but the Q1 weakness was attributed to slower business in

the broadcast space. If the broadcast space doesn’t come back quickly then

Belden may not be able to grow organically in ’15. Management assures me that

the broadcast business will be fine, but I just hope the Q1 miss doesn’t portent

further earnings disappointments.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Between MSD organic growth, substantial margin expansion, value added

acquisitions, and buybacks, EPS should be able to grow mid-high teens

sustainably. This should lead to a re-rating of shares away from the commodity

cabling companies and towards capital compounders like APH and DHR.

I believe a sizable portion of this rerating will occur between 2Q15 and 4Q16.

show sort by

			2015	2016
Price:	84.90	EPS	5.41	6.13
Shares Out. (in M):	43	P/E	15.7	13.8
Market Cap (in $M):	3,680	P/FCF	20.9	17.4
Net Debt (in $M):	1,672	EBIT	393	430
TEV (in $M):	5,352	TEV/EBIT	13.2	11.9