Description
Summary
CommScope (“CTV”), a manufacturer of cables and interconnects, has sold off approximately 36% over the last couple of months providing a great entry point to invest in a best in class management team taking on a significant transformative acquisition of Andrew Corporation (“ANDW”). Excluding ANDW, CTV is trading 10.5x 2008E and 8.8x 2009E free cash flow; this assumes margins stay flat at current levels and growth gets cut in half from the current rate. A 13x-15x multiple on 2009E free cash flow gets you to $54-$61/share or over 34%-50% upside from current levels and a very nice free call option on the turnaround of ANDW, which, due to mismanagement and poor capital allocation decisions, has significantly underperformed the sector. CTV management has a great track record in turning around underperforming acquisitions. If they can improve margins, then previously announced synergies should prove well below our expectations. Thus, as Andrew’s margins dramatically improve due to better cost controls, pricing discipline, capital allocation, and much higher synergies than have been announced publicly, the upside for the stock could be significant.
Business Description
CommScope and Andrew combined will be the leading global provider for the “last mile” in communications networking for video, voice and data mobility applications. This includes structured cabling solutions for business enterprises for HFC applications globally and wireline (CTV) and wireless (ANDW) communications infrastructure. Combined the business will have just under 50% of its businesses outside North America with significant exposure to emerging markets.
CommScope’s Business Summary
70% of sales come from North America and the 30% from the rest of the world which is growing rapidly. Despite CTV’s dramatic growth in revenues and margins over the last several years, we believe that long-term growth will still be maintained at a healthy rate in the 8-12% range mainly due to the strong tailwinds helping the industry as discussed below.
CTV’s business has grown substantially over the last several years benefiting from some major trends in its three major business units which include:
- Enterprise (2007E: $915MM sales, $150MM in op income)
- Products: Sells structured cabling systems that connect voice and data communication devices, video and building automation devices, switching equipment, etc.
- Drivers: The main driver is the growing need for faster and bigger bandwidth to handle the increased data throughput; this is due to the addition of new software applications, a rapidly increasing number of different IP devices (e.g. laptop, phone, blackberry, desktop, music players) on the network. The globalization of IP networks has also helped fuel growth as true global integration between different offices , call centers, factories, etc. can best be done via one common IP-based platform. As a result, enterprise is experiencing strong tailwinds which should continue for many years
- Broadband (2007E: $627MM in sales, $75MM in op income)
- Products: Provides coaxial and fiber optic cable for cable television and other video applications
- Drivers: A major driver for growth is the continued competition between the MSOs & Telcos in providing video, voice and data services (HDTV, VOIP, VOD). The bandwidth requirements for these services continue to grow exponentially
- Carrier (2007E: $355MM in sales, $57MM in op income)
- Provides cable for wireless transmission systems and environmental secure cabinets for DSL/FTTN. Note that this unit was losing $35MM when CTV bought it as part of the Avaya acquisition
- Most of the growth for the unit has been from AT&T’s project Lightspeed deployment, which is AT&T’s plan to offer IP-based TV service for residential applications
Andrew’s Business Summary
ANDW is the leading global supplier for wireless infrastructure subsystems. The company is broken down into the following segments:
- Antenna and Cable products (9/30/07: $1.4bn in sales, $218mm in op income) – cable/cable products, base stations and microwave antennas
- Base Station Subsystems (9/30/07: 404MM in sales, ($25MM) in op income) – power amplifiers, filters/combiners to OEM and operators
- Network Solutions (9/30/07: $87MM in sales; $2MM in op income)– geolocation systems, network optimization software
- Wireless Innovations (9/30/07: 188MM in sales; $42MM in op income) – provides in-building and dense urban coverage systems with repeaters, boosters, duplexers, indoor antennas
The major trends that are supporting ANDW’s growth over the past several years are the global growth of handsets and global subscribers necessitating network upgrades and higher bandwidth requirements. From a regional perspective, maturing markets are moving to higher bandwidth applications due to mobile video service. Emerging markets such as India and China are seeing unprecedented growth in the wireless market creating significant pressure on their networks. Another important driver is the more mobile work force both in the U.S. and abroad. Laptops have now over-taken desktop sales and there is a growing need for more flexible work environments. North America represents just 46% of sales, while Europe, Middle East and Africa are 32%, Asia-Pacific is 15% and Latin America is 7%.
What created the buying opportunity?
There were several events that probably led to CTV stock falling as much as it has. First, CTV lowered guidance after announcing Q3 results which drove the stock down 10%. Instead of guiding to $1.9-$1.94bn in sales, the company guided to $1.89-$1.91bn in sales – a .5 to 1.5% revenue miss – hardly a significant miss. In terms of operating margins, the company guided to 14.75-15% instead of 15.25-15.5%. Note that guidance was raised to these levels after announcing Q2 results, which had previously been $1.84-$1.89bn in sales and 13.5-14.5% margins. Also note that management is always conservative in their guidance.
Secondly, recent comments by Cisco’s CEO with respect to a slowdown in corporate IT spending in the US did not help the stock even though growth would still be in the high single digits driven by international growth (where CTV/ANDW will have just under 50% of their revenues). Also, a slow down from Cisco means going from the mid 20s to the mid teens, not negative growth.
Third, there is a lot of speculation on AT&T buying Dish or DTV. Should that happen, there is a question on whether AT&T will need to deploy Project Lightspeed (U-Verse), their fiber to the node (FTTN) next generation telecom/video solution, as video would be offered through the satellite business (DISH). The simple fact is that project Lightspeed must keep going for ATT to have a fast two-way network of equal or greater speeds to the cable companies (MSO). Further, there is good reason to believe, as does management, that Bellsouth will roll out Project Lightspeed as well.
Finally, the market is shorting anything that is even remotely affiliated with residential and increasingly commercial construction. In reality, half of CTV’s enterprise business is international and only 20% of the enterprise business is related to new construction build. We think these concerns are an over-reaction and believe that CTV will provide outstanding returns to patient investors as the Andrew turnaround takes place.
Investment Highlights
Strong Management
CTV has a great management team that has been together for 30 years and has operated in almost every financial/economic environment. They have a long history of integrating and successfully acquiring companies with the most recent one being the Avaya Connectivity solutions business in 2004. In the three years since owning Avaya, this management team has grown its sales by 50% and increased operating income by 4x. This management team has a history of under-promising and over-delivering and we are highly confident that they are doing it again with Andrew.
High Barriers to Entry
The combined companies have leading technologies backed by over 2,000 patents which cannot be replicated easily. Additionally, CTV has transformed itself from being just a cable provider to a total system solution provider for “last mile” communications infrastructure. CTV sells packages which includes connectivity and will only warranty speed/throughput if their products are used across the entire network. Such an offering is very appealing to fortune 1000 companies because of the mission critical nature of their IT systems and an inherent bent toward standardization. The other major advantage for CTV is the penetration of their products. If it is not a newbuild, it is natural to simply just upgrade whatever infrastructure is already in place – which is most often CTV or Belden products. Finally, CTV’s scale in procurement, logistics, and global manufacturing capabilities make it very make it difficult for smaller and regional competitors to compete effectively.
A lot of low hanging fruit to pick at Andrew
There is significant opportunity for CTV to improve Andrew’s operating performance including the following:
Pricing Discipline
· Andrew is the number one provider for wireless infrastructure solutions in their respective end markets, yet has not fully taken advantage of their dominant position. Gross margins have dropped from 24.5% in fiscal 2004 to 21.4% in fiscal 2007 due to commodity raw materials increasing. CTV, on the other hand, has increased gross margins substantially from 23.4% in 2004 to 30.5% for LTM 2007
Operating Discipline
· Andrew has acquired ten companies around the world totaling $170MM over the last four years. Since then, the company has constantly been undergoing restructuring without any improvement to its operating statistics. CTV’s management has a history of successful integrations and should provide the much needed operational excellence for Andrew
· From a working capital perspective, CTV has significant opportunity to improve ANDW’s efficiency and cash conversion cycle by improving inventory turns and receivable days. CTV turns its inventories almost 2x as fast as Andrew and is paid 2x as fast. Andrew turns its inventory every 80 days and is paid every 100th day while CTV turns its inventory every 43 days and is paid every 40th day. Every turn of inventory is worth approximately $67MM in unnecessary working capital and every turn of receivables is worth approximately $99MM. Admittedly payables would come down as well and would impact working capital negatively, but it enables them to keep a leaner balance sheet.
Capital Discipline
· Capital was not being allocated efficiently by ANDW’s management team. Over each of the last three years, management had spent $14.5MM on satellite communications and $42MM on Base Station Subsystems. Both of these businesses have negative operating margins (excluding allocating corporate overhead) and have only gotten worse in the last three years. Note that another $38MM of capex was unallocated to a business unit and was spent on corporate, IT, human resources, etc. over the last three years
· Andrew spends between 5-5.5% of its sales (over $100MM) on R&D while CTV spends under 2% of its sales on R&D. We approximate that $50MM is spent on Base Station Systems, which is just under half of the R&D spend. Network solutions make up another $16MM of R&D spend for a business that is generating 2% operating margins excluding corporate overhead. This compares to CTV, who spends a total of $30MM on R&D/year.
Synergies will be much higher than stated
CTV has publicly announced that it expects Andrew acquisition synergies would be $50-60MM in year 1 and (a cumulative) $90-100MM in year 2. Much of this total is for purchasing synergies as only a 1% decrease in raw materials would equal over $20MM in pre-tax savings. This is extremely conservative given that Andrew has approximately $114MM of unallocated SG&A which was for senior management payroll, human resource, IT, finance, legal, and public company costs. If CTV cuts only 80% of this you are already at the low end of the synergy guidance excluding other major synergy opportunities which include:
o Rationalizing 35 combined global factory and distribution locations
o Transferring CTV’s technology knowledge in coaxial cable and applying it to Andrew’s global channel for wireless infrastructure. The conversion of copper to aluminum greatly enhances margins given the different in raw material pricing for both
o Revenue synergies could be dramatic with new channel and product opportunities for both the wireless and wireline products. A few examples include the following:
§ 25-30% of CTV’s workforce is in sales (approximately 450 people worldwide) and there is an opportunity to push wireless product through this workforce (e.g. it happened with Avaya)
· ANDW provides wireless products mainly through Carriers while CTV’s largest channel is in Enterprise. To have the ability to go to Fortune 500 or any of CTV’s thousands of customers around the world and say they can provide both the wired connectivity and wireless connectivity solutions seamlessly will be a great marketing opportunity
§ CTV’s cabinet business is largely sold to wireline carriers and CTV believes there is an opportunity to move the capability to wireless carrier channels where ANDW is dominant
§ CTV’s Broadband business should benefit by being able to offer RF Connectivity (wireless) into CTV’s traditional MSO space
Depressed 2007 capex by Andrew’s customer will bode well for 2008
Two customers, Cingular and Alcatel/Lucent, combined spent $200MM less on wireless equipment in 2007 than the previous year. This represents 10% of revenues and could be a nice lift for the combined companies next year. After speaking with these customers we believe that wireless capex spending for 2008 will return to normal levels well above 2007.
Valuation:
We valued CTV separately using the following assumptions:
- Revenue growing in the high single digits with essentially flat operating margins
- Total annual capex of $30MM, tax rate of 32%, net zero interest expense
This gives us free cash flow of $230 MM for 2008 and $250MM for 2009 respectively for CTV standalone. With the current enterprise value of $2.4bn decreasing to $2.2bn after taking in the cash generated in the next quarter and for 2008, CTV standalone is trading at 8.8x 2009E free cash flow (FCF). 14x 2009 FCF would yield a $60 stock or 50% upside from here excluding any upside from Andrew.
There are several potential scenarios for Andrew. One scenario is that CTV keeps all the businesses (excluding Satellite Communications which has already been sold) and begins turning them around. If we assume high single digit growth and operating margins improve to 8% by 2009, free cash flow will more than double in two years to around $170MM. This also assumes that capex is reduced significantly to $30MM which is not unrealistic as the company has already had 20 facility relocations over the past several years and has built several new state of the art manufacturing facilities.
To ANDW’s free cash flow, we added synergies of $120MM (after tax around $80MM) for 2009, which is greater than was estimated by management team but still very conservative. Finally, we subtract new estimated interest expense from the acquisition of around $121MM in 2009. We arrive at close to $380MM in free cash flow for the combined company. A 15x multiple gets you to the mid $70’s for the combined entity, which is 85% upside from current levels.
Risks:
- Macro economic conditions get much worse and curb spending by enterprise customers
- Andrew turns out to be more difficult to fix
- Raw material prices continue to increase and pricing does not help alleviate increased costs
- Margins deteriorate as competitors get more aggressive on pricing
- Spending by Telcos & MSOs gets delayed due to change in strategy or M&A
Catalyst
• Continued growth in revenues and earnings
• Successful integration of Andrew Corporation and increasing synergy targets