Description

TEL is misvalued as investors are not properly valuing the business transition over the last three years as management has sold commodity businesses while buying specialized component companies. I believe fair value for the stock is $56 at 12x 2014 EPS, offering 60% upside.

Background:

Post its spin from Tyco in 2007, management has undergone a process of transitioning the company from a commodity connector company to more a specialty business. Their message is that they’re trying to become a company that ‘solves connectivity problems’ rather than a connector company through very specialized connectors designed into markets with long design cycles and barriers to replacement. As part of this process, they’ve divested $1.8bln in commodity businesses and make two acquisitions, ADC at $1.1bln in 2010 and most recently Deutsch at $670m in early 2012. They’ve also restructured their manufacturing portfolio in this process by closing down high cost manufacturing plants in the west and improving their presence in emerging markets to be closer to the supply chain. They’ve noted that while they’ve made some strides in closing down facilities, they’re currently attempting to improve factory utilization through LEAN cost savings for better asset utilization. They’ve said they’ve just started this in some factories and are only about 20% of the way through the process. Also, as part of the restructuring process, they’ve reduced the number of distributors they use and are shifting towards partnering with a few larger distributors so their interests are more closely aligned. Management has said that while they’ve finished the process of consolidating their distribution network, they haven’t yet seen most of the benefit of their distribution partners pushing sales of their products.

Acquisitions

Part of their strategy is growth by acquisition. They target acquisitions that they believe have good products and are growing/will give them a foothold in a new industry. They note that ADC gave them a god product set in fiber network connectivity which is now 15% of revenue and extremely complicated work that cannot be replicated easily. Deutsch also gives them access to a totally new product line that they’ve had trouble developing internally, round connectors for harsh environments. While ADC was more of a turnaround, Deutsch was purchased at fair value but management believes acquisitions of great companies like this don’t come around very often and are targeting a 11-13% ROIC vs. a 9% cost of capital in 2013 and believe that given no customer/product overlap, they can increase Deutsch’s growth rate from 6% over the last few years to 8-10% as part of TEL. It also diversifies the company’s revenue stream, so macro weakness in a single sector won’t cause massive margin volatility on a quarterly basis.

They are positioning themselves to exploit growth around greener/more efficient transportation, data growth (both fixed and wireless), increased automated production and improved electrical infrastructure. They believe they are one of the few companies that can provide connectors that will withstand the harsh environments and complicated design of products for these trends.

2015 Targets

In their last analyst day, management laid out their three year targets. They expect to hit $20bln in revenue at 18% ROICs and $5.50-6 in EPS (EPS being a proxy for FCF). They hope to do this by gaining share in emerging markets, capitalizing on acquisitions (they plan to only spend another $500-600m in acquisitions over the next 3 years) while focusing on targeting sectors with long term secular growth.

Business Segments

Consumer—$2bln in FY2011 revenue or 15% of total revenue

In the consumer segment, TEL makes connectors for three major end markets, appliances ($800m in FY11 revenue), consumer devices and computing ($1.2bln between the two). This has been the weakest segment for the company and the most commoditized given the mainstream/mundane nature of the end markets (no one will die or a multi-million dollar machine will not be destroyed if an appliance or a computer stops working). The company has not done well in consumer devices/PCs and the CEO has noted that this is because of the shift to smartphones/tablets. He’s said this is the fastest change he’s ever seen and the company was ‘riding a couple horses’ that didn’t grow. He has said they’ve reorganized this business and brought in a new leader in early 2011 and believe that the business is stabilized and hopefully growing going forward. He said it will take another year for the business to turnaround and begin to grow but that he’s confident in the new team. Appliances has also performed poorly due to weak housing but is fairly stable longer term. In consumer as a whole, the company expects 4-6% long term growth between now and 2015.

Energy and Industrials--$4.1bln in FY2011 revenue or 28% of total revenue

This segment consists of industrials ($1.6bln in FY11 revenue), energy ($900m in revenue), aerospace, defense & marine ($700m in revenue), industrial transportation ($500m in revenue) and touch screens ($400m in revenue). This segment is basically the hodgepodge of end markets that doesn’t fit into auto, telecom or consumer. They make specialized connectors in each segment except for touch where they make fairly commoditized touch screen devices. Deutsch will be included in this division, mainly within aerospace, defense & marine and will help the company to win new customers in this division that they can also sell their current products to. The largest growth driver in this division is automation of industrial equipment. Management believes automation within factories as wages in emerging markets increase will drive growth in industrial machinery. Given the large number of connectors, many different customers, geographic dispersion and long design cycles management has said that this is not the sort of business that can be built overnight and has good growth potential. They expect 6-8% long term growth in this segment and corporate average margins.

Automotive—largest single segment at $4.4bln or 31% of total revenue

In 2011, there were 77m cars produced annually. TEL expects this to grow to 100m by 2015. They also expect 20% growth in content per car and 37% annual vehicles sales growth in China. TEL is the #1 in this market with 36% market share with a sales force that’s mainly on-site with their customers. In terms of secular trends, TEL expects to benefit from the general content growth of connectors as cars become more automated (increased driver assistance like the Mercedes vibrations when a customer goes off course, increased navigation use, infotainment) and as more electric cars are built. Management expects content growth/car to be in the 4-6% range. They also expect growth in the auto infrastructure market—as new electric charging stations are built, there will be an increased need for new connectors. Shorter term, management has said there will not be much growth in South American given recent increased auto inventories (certain regulation caused an overbuild of cars that needs to be worked down), while Europe remains the market with the most uncertainty. Their sales into Europe in the division is small (despite an optically high exposure into Mercedes, BMW, Audi and VW—most of which are actually shipped elsewhere) but there will be weakness at the Southern European OEMs (in Italy and France that mostly service the domestic markets). They except the segment to be healthy as a whole, driven by growth in Asia and expect 7-9% annual growth.

Communication Networks Business--$3.7bln in revenue or 26% of total

ADC has been integrated into this division. The major driver here is growth in broadband both fixed line (through increased fiber builds worldwide) and wireless (through increased fiber in base stations for wireless backhaul congestion) as fiber replaces coaxial cable. Specifically, the business is broken down into data communications ($1bln in revenue) where growth is driven by more data centers, enterprise networks ($700m revenue), telecom networks ($1.5bln revenue) where growth is driven by more integrated/connected networks and subsea communications ($600m).  Subsea is a more cyclical market, driven by when telecom companies undergo large fiber builds. The business is lumpy but management believes it should grow long term. Management believes the business should grow 6-8% annually over the next three years (driven by 6-8% broadband connectivity growth, 5-7% data communications growth, 7-9% enterprise growth, and 7-9% telecom networks growth). In pretty much all of these businesses, fiber is put into the ground and not dug up again so the value of a connector that doesn’t fail is very important given the cost to tear up a city block just to repair a connection.

Deutsch Acquisition—Is Management Empire Building?

The acquisition was seen as inopportune when management had previously said they were planning on buying back more stock. Moreover, at 7x EBITDA, the street was upset that the company didn’t buy back more stock, given that TEL was trading at 10x earnings and 6x EBITDA. Management countered that there are very few acquisitions that fit well within TEL and Deutsch is one of them and that they didn’t expect Deutsch’s owners to sell the company so soon. In their long term 2015 targte revenue of $20bln, TEL only expects to do another $500-600m in acquisitions. I think we can be pretty confident that Deutsch is a special situation and that TEL’s management are not empire builders, but are focused on long term ROICs.

Poor Investor Communication

I think the quality of the business/barriers to entry are not as much of the reason for the low earnings multiple on the stock but more closely related to the company’s history and communication with Wall Street. At their investor day in Dec 2011, they guided to $3.4-3.5bln in revenue and $0.68-0.72 in EPS but ended up earning $3.3bln in revenue and $0.66 in EPS. They also lowered their FY12 revenue mid-point by $600m from $14.6bln to $14bln with $400m related weakness in European infrastructure/industrial and North American telecom spending and $200m related to weakness in the Euro.  While this wasn’t a large earnings miss, it signified to the investor community that they don’t have much visibility in the business since they had only a few more weeks in the quarter after the investor day. This also highlights the short term macro related risks in the business. Also, given the company’s historically commoditized products and history with Tyco, investors aren’t necessarily giving them the proper multiple to reflect significant R&D spend, not easily replicable products and the divestitures of poor businesses for better ones. FQ2 earnings were about as expected though the company slightly lowered FY12 guidance to account for lumpiness in their undersea business and slower than expected demand pickup in industrials as well as the sale of their touch screen business.

Valuation

The company’s discussion of its business segments highlighted above do not fit its currently reported business units so, while we have revenue breakdowns for each segment, operating margins are only broken down for the three major segments, transportation, communications/industrial and network solutions. I drive my revenue projections based on targeted incremental EBIT margins in each business.

For FY12, I get to $13.975bln in revenue and $2.91 in EPS vs. guidance of $13.5bln-13.8bln and $2.88-2.98. I am slightly above guidance based on continued sequential growth in each segment between Q3 and Q4. I am slightly below on EPS because I think gross margins don’t improve as quickly as management expects. I could be wrong here but they’ve already gotten pretty good auto operating leverage over the last couple quarters and the Deutsch related operating leverage doesn’t really kick in until 2013.

Assuming they begin their buyback in FY13 (they said it will be in FQ4 2012), we get to the following EPS and PTs.

No Buyback

FY12 EPS/Target--$2.91/$34.90

FY13 EPS/Target--$3.69/$44.31

FY14 EPS/Target--$4.17/$50.04

FY15 EPS/Target--$4.70/$56.38

Buyback (assuming 65% of FCF used for the buyback)

FY12 EPS/Target--$2.91/$34.90

FY13 EPS/Target--$3.93/$47.14

FY14 EPS/Target--$4.74/$56.88

FY15 EPS/Target--$5.74/$68.87

I don’t think a business like this should trade at 10x earnings since the qualification process and the design cycle for the auto industry and the telecom industry is fairly long. There is no pricing erosion and both of their major markets are secularly growing. Deutsch also provides them with increased end market diversification and an increased specialized product set. I think that even hitting their guidance over the next several quarters will cause an expansion in the multiple to that of an APH or MOLX.

Catalyst