Description

Thomas & Betts (TNB) is a leading manufacturer of electrical components for industrial, construction, and utility markets.   The Company also manufactures highly engineered steel transmission structures for the electricity industry and commercial grade HVAC systems.   Founded in 1898, the company built its brand and reputation on establishing and managing deep relationships with its distributors.  After an ill-advised acquisition in 1992 and subsequent distraction by the internet bubble in the late 1990s, the company refocused its strategy and announced a restructuring program in late 2001 - reducing its workforce by 29% and facilities by 22% -- which was led by then COO, Dominic Pileggi, who became CEO in 2004.  The company generated revenues of  $2bn and $2.2bn for the twelve months ending December 30, 2010 and  June 30, 2011 respectively with EBITDA of 301m and 336m during those periods.  In 2010, 62% of the company's revenues are from the U.S., 19% from Canada, 12% from Europe, and 7% from rest of the world.  Key end markets are construction (primarily nonresidential; 41% of revenues), Industrial (35%), and utility (24%)

TNB's electrical components segment, which comprises 84% of revenues (and hence the writeup will largely focus on this area), generated $1.7bn of revenues in 2010 with adjusted EBIT of $324m.  Its broad portfolio consists of over 700k SKUs which are mostly critical, non-discretionary products, such as electrical fittings, connectors, switch boxes, and emergency lighting.  The company chiefly sells though distributors and retailers, and occasionally sells directly to utilities, telecommunications, and OEM mfg customers.  Its chief competitors are Cooper Industries and Hubbell, though it should be noted that electrical components are a much smaller percentage of revenues for these two competitors than for TNB.

The steel structures segment (11% of revenues) generated 2010 revenues of $220m and EBIT of $35m.    This segment designs and manufactures engineered tubular steel transmission and distribution poles for utility, telco and other applications.  The company focuses on highly engineered application-specific monopoles, and  its main competitor is Valmont Industries.  Though margins in this business have greater variance, depending on the ultimate end market for the product, its pipeline provides more visibility. 

 Finally, TNB's HVAC segment (6% of revenues) provides a product suite ranging from standard products to highly-customized solutions. 

Investment Thesis

At $40 per share, TNB is trading at approximately 6x 2011e EBITDA, and at a 10% free cash flow yield.  Given the high quality nature and stability of the business (chiefly its ability to maintain margins in recessionary environments), very capable management team, and current valuation, we believe the company is undervalued by approximately 30%, with very limited downside. The company is far better situated than it was prior the 2008-2009 recession from a cost structure, balance sheet, and competitive dynamics positioning, and hence, even in a double-dip recession scenario, we believe that the company will still be able to generate nearly $3.00 of after-tax free cash flow, thereby providing a margin of safety against permanent capital impairment.  This is not the most exciting investment out there, but rather an opportunity to invest at a significant discount in a well-run, well-situated company that should continue to accrete value for years to come.  For a company that is painted with an industrial/cyclical brush, the company's margins and free cash flow generation are about as steady as they get.

High quality and stable business

TNB is a high quality, relatively stable business for the following reasons:

Essential products in a attractive end markets

Not only does TNB provide a broad portfolio of leading brands that are well-regarded for their quality, but such products are largely non-discretionary.  The brand strength enables TNB to pull demand through distributors rather than the typical push model, and its broad portfolio provides a tremendous advantage.    TNB's end-users view its brands as the "brand of choice", and provides the lowest installed cost solution (rather than the lowest cost price - in other words, factoring in things such as transportation costs, servicing, etc).

Additionally, TNB, while somewhat exposed to the construction market, benefits from industrial production (i.e., the opex side rather than capex), and the steel structures segment provides exposure to the expansion of the transmission grid over the next several years.

Competitive advantages and positioning

Put simply, TNB doesn't have a true head-to-head competitor, as (i) most of their competitors are fragmented small to medium-type companies; and (ii) the other "large" competitors - i.e., Cooper and Hubbell - are focused more on their core businesses, and view their electrical business as a stable cash cow to fund the growth of such core businesses. 

As a result, TNB is able to leverage its fast-cycle logistics system (which lowers transaction costs and working capital requirements for distributor customers), its "one order, one invoice, one shipment" distribution system, and its deep relationships with distributors as well as end customers to provide the lowest installed cost solution (rather than the lowest cost/price) as distributors prefer to receive several parts from one supplier rather than a host of parts from several suppliers.

Sustainable and visible margins

Due to its embedded competitive advantages outlined above, TNB has done a terrific job sustaining margins through various business cycles and generating prolific free cash flow.  In fact, during the 2008-2009 downturn as illustrated below, despite a 26% drop in revenues, the company was still able to maintain an EBITDA margin of 14.5%, versus its prior three years average of 16.4%.  

TNB's ability to sustain EBITDA margins in the mid-teens through various cycles is due to the mission critical nature of  its products and pricing power.  Despite the company's exposure to steel and other commodities, TNB has generally been able to pass through raw material price increases.  In fact, in the last nine months, the company has put through three price increases

Notably, the company has not recovered in its topline from pre-2008 levels, and channel checks indicate that distributor inventory levels are currently low. 

 Solid management team

The CEO, Dominic Pileggi, has been with the company for nearly thirty years, rejoining the company in 2000 as president of the Electrical division.  He was subsequently appointed to COO in 2002, and CEO in January 2004.  Throughout his tenure, he has developed a reputation for his ability to enhance market positioning of products, growing organic sales and earnings, and managing the cost-side of the business in a very efficient manner.  Most importantly, he took over a company that had lost its way over the five years prior to his return to the company, as TNB had made some ill-advised strategic decisions and acquisitions, and suffered through an accounting scandal.   

In an industry that relies on deep relationships along the vertical chain (manufacturer to distributor to end customer), Dominic and his experience team are well-regarded and have developed deep ties over their long careers.

The company's acquisition strategy under Pileggi has been prudent and thoughtful, and they have repurchased shares opportunistically over the last several years.

Cheap valuation w/ a solid balance sheet

TNB currently trades at approximately 6x 2011e EBITDA and a 10% free cash flow yield - a significant discount to both its historical multiple of 8x EBITDA and comp multiples of 9x.  More importantly, while an argument can be made that we may not have hit a trough environment, the company's revenues are still (on an organic basis) nearly 15% below 2008 levels.

Over the last four years, through the recession, the company reduced its net debt from $662m to a $115m as of June 30, 2011.  Meanwhile, the company has consistently generated nearly $4.00/share of free cash flow (CFO-Capex) over the last five years, in spite of the turbulent economy.    Indeed, this reflection of the prolific and consistent cash flow generation of the company is set forth below: 

A return to comp/historical multiples and continued execution of its business plan would yield a stock price of approximately $55-$60 per share a year from now.  The company is also a potential takeout candidate by either a financial or strategic (e.g., Cooper) buyer.

Risks/Bear Case 

Double dip recession

Capital allocation (company makes a poor decision/acquisition)

Catalyst