We recommend buying shares of TE Connectivity (TEL). The company’s shares trade at about 9x our estimated FY2014 earnings, which we consider to be inexpensive for a company with the potential for 6% to 8% organic revenue growth and double-digit EPS growth (which is fueled by increasing worldwide electronic content growth).
TE Connectivity (formerly known as Tyco Electronics) was spun-off from Tyco International in July 2007. In 1999, CEO Dennis Kozlowski acquired two companies (AMP, a leader in connector technology, and Raychem, focused on material science) to form the basis of the current TEL. Additionally, Kozlowski (in more optimistic times) made several other acquisitions for Tyco’s electronics division, although many have now been divested (prior to two recent larger acquisitions, about 80% of the business is the old AMP and Raychem businesses). More recently, TEL has changed its domicile to Switzerland (from Bermuda) and has acquired ADC Telecommunications (network equipment) and Deutsche Group (harsh environment connectors).
The company, which should have about $14.5 billion in sales in FY2013, is a leader in connector systems (60% of the company’s revenue) and other electronic products (such as relays, sensors, fiber optics, antennas, and undersea telecommunication systems, etc.). The products are generally engineered for custom applications (about two-thirds of its business), while the remainder might have competition. The connector business is approximately a $50 billion market, with the top ten participants (which would also include Amphenol and Molex) holding a 50% share. Overall, TEL believes that its total addressable market (including non-connector markets) is $90 billion and growing at 6% per year. TEL’s top end markets (in 2011) were:
Auto – 34%
Telecommunications – 14%
Industrial – 8%
Telecom Networks – 8%
Energy – 7%
Computer – 7%
Enterprise Networks – 6%
Aerospace & Defense, Marine – 5%
Appliance – 4%
Medical – 3%
Others – 4%
As mentioned above, TE’s markets grow at about 6% per year (worldwide automotive production, as an example, obviously grows slower than 6% per year but there is a trend of increasing electronic content per vehicle). The company believes that it will grow 6% to 8% organically and additional tuck-in acquisition will add 2% to annual revenue growth. Margins should expand somewhat as the company leverages volume growth (recent growth has been sub-par, so there is unabsorbed overhead, etc.)… we would anticipate operating margins expanding 180bp or so by FY2014. With share repurchases (following the Deutsche transaction, management is increasing its emphasis on repurchases), we would expect double digit EPS growth. Free cash flow should equal net income (working capital and fixed investment might grow, but the cash tax rate should be in the mid-teens long-term versus a GAAP tax rate of 26% or so).
The company has guided FY2012 (year ends September 2012) revenue of $13.3B and EPS of $2.84 (both are mid-points of actual guidance). We think organic revenue (excluding the “lumpy” subcom unit) will grow 7% in FY2013, Deutsche will add an incremental $370 million of revenue growth and subcom will be about flat. This would lead to EPS of about $3.50 based on a 14.5% margin (up 130bp y/y) and a slight reduction (perhaps 1% or 2%) in shares outstanding. For FY2014, we would expect $15.5 billion in revenue, 15% margins, a ramp-up in repurchases and approximately $4.00 in EPS (this compares to the company’s FY2015 target of $5.50 to $6.00 of EPS, which we think is overly aggressive). At 13x earnings, we would expect TEL to trade at $52 per share in mid-FY2014 (or March 2014)… or a CAGR of just over 30% when including dividends; at 15x earnings, we would expect a $60 share price or a 45% or so CAGR.
Inexpensive valuation at 9x estimated FY2014 earnings. In addition, shares have underperformed due to a recent large acquistion (Deutsche) that many have considered expensive; however, it is unlikely that management pursues additional large acquistions and instead focuses on repurchases and dividends.