Description

Executive Summary:  Amphenol is a leading manufacturer of electronic and fiber optic connectors, antennas, and sensors with ~$8bn in sales. Broadly, a connector is a device that takes data or power from one input to another with the aim of minimizing power loss and maintaining the signal strength during transfer. These are components that do not cost much as a percentage of the end product’s overall cost but are critical to the proper functioning of all electronic devices. It is a huge (~$175bn), fragmented, and growing market that has benefited from the proliferation of electronics into just about everything we do.

The company has enjoyed steady top- and bottom-line growth over the past 2+ decades by pursuing a strategy of broad diversification (end markets, geographies, customers) that helps shield it from end market volatility, and has complemented its attractive +MSD organic growth profile with a successful bolt-on M&A strategy. Since 2003, sales have increased 13% annually with just one down year (2009).

Amphenol runs a decentralized operation with a flat organizational structure that fosters an entrepreneurial, performance-driven culture.  Its 120+ general managers worldwide have total authority of their businesses and are held completely accountable for their performance. GMs are incentivized to think entrepreneurially to solve customer needs in a cost-effective manner. They have access to the firm’s resources and are encouraged to collaborate with other business units, but ultimately can run their business as they see fit. The result has been an agile business with strong profitability that can react quickly to changing market conditions. Operating margins have averaged 19.1% since 2003 (19.8% over last decade), and only fell 220bps in 2009 and 160bps from 2000-2002.

While results have softened since mid-2019 on account of the trade war with China and now the challenges related to COVID-19, Amphenol is well-positioned to benefit from a cyclical rebound in volumes in 2021/22. And longer-term, we see no structural reason for why the trends driving adoption of interconnect would abate anytime soon. Assuming the company can continue to deploy ~70% of cash flows into capital investment and M&A, 15-20% into dividends ~(1% yield currently), and 40% into repurchases, we estimate the company can continue to compound cash flow per share at a low-to-mid-teens rate.

At ~$110, shares look expensive on near-term (cyclically depressed) estimates at 33x/27x FY2020/21 earnings vs. a 5yr/15yr forward average of 24x/21x, but valuation looks much more reasonable on a normalized basis (we estimate ~25x normalized forward cash flow) and we see potential for upside to estimates via prospective M&A.

Company Overview: Amphenol Corporation (APH) is a leading designer and manufacturer of connectors, interconnect systems, antennas, specialty cable, sensors, and sensor-based systems. The total addressable market for interconnect and sensor products supplied by APH is estimated at ~$175bn, implying the company has 4-5% market share. The company has two reporting segments: (1) Interconnect Products & Assemblies and (2) Cable Products and Solutions, but the segments sell complementary products and tend to have a fair amount of overlap between end markets and customers.

Besides the two segments, management reports product sales by 8 different end markets. The company is broadly diversified, with no end market larger than 20% of sales. The company has leading market share in aerospace and defense (~30% share is ~2x the next largest player), is the #3 competitor in Auto (behind TEL and APTV), and is #2 in Industrial (behind TEL). The company also enjoys very strong market positions in mobile devices (particularly with Apple), networks, and IT and Data Communications, having invented the standards applications.

Connectors Overview: A connector is a device used to transmit a signal or power from one input to another with the aim of minimizing power loss and maintaining the signal strength during transfer. There are thousands of types of connectors used for a diverse set of end applications such as auto infotainment systems and air bags, PCs, communication equipment, and smart phones. Connectors are components that are rarely thought about by the end user and account for just a fraction of the product’s total costs but are critical to any electronic device’s proper functioning. It is a huge (~$65bn), fragmented, and growing addressable market that continues to consolidate through a combination of strong organic growth and bolt-on M&A from the market leaders.

In 2018, the top ten connector suppliers (out of ~1,000 industry participants) accounted for ~60% of sales (up 1,000bps over the past 20 years), the next 90 suppliers account for ~35% of industry sales, and the remaining hundreds of companies account for the final 5%. Notably, Amphenol has been the biggest beneficiary of market consolidation by far.

Decentralized operating structure that encourages entrepreneurial management style:  Amphenol is extremely decentralized, operating with a flat organizational structure that fosters an entrepreneurial, performance-driven culture. Its 120+ general managers worldwide have total authority of their businesses and are held completely accountable for their performance. GMs are incentivized to think entrepreneurially to solve customer needs in a cost-effective manner and are tasked with growing their business and actively pushing margins higher. They have access to the firm’s resources and are encouraged to collaborate with other business units when possible, but ultimately can run their business as they see fit. This has fostered a culture of agility that allows Amphenol to react to changing market conditions rapidly, helping protect profits in difficult macro environments and maximizing results where demand is strong.  

We spent 2 decades building a culture of a company that has then the inherent agility at the street management level to react to changes. That's #1 thing we do. That's not something you can do overnight. It's something we spent the better part of 2 decades incubating and developing in the culture of the company. And I think I have mentioned many times in the past, for those especially who followed us through many cycles, that in a time of turbulence, this is really when the Amphenol management team excels the most because we have around the world 90-plus general managers. Those general managers are facing customers every day, and they're going back from the customers with the information that they have gathered and they're going into the factory to allocate and arrange their resources. And you can bet in [un]certain times, that they're hearing from customers not positive news, and when they're hearing not positive news, they don't report to someone who reports to someone who reports to someone at headquarters and then we make sort of a big decision about what to do. They go back to their factory to say, "Hey, I don't see the orders. I better adjust my resources." And that can mean cutting cost with people, that can mean cutting spending, that can mean redeploying towards growth opportunities, whatever it is. That's the essence of the agility that is embodied and really across this entire organization. So in a time like this where everybody wants to sort of buckle their seat belts because it doesn't feel like a very smooth flight, this is when the Amphenol team buys new pairs of shoes, gets out there, makes sure that they're getting real-time information from customers, goes back, make some real-time cost adjustments, real-time resource reallocations to make sure that we preserve strong operating performance and we expand our market position. That's the playbook that we have had through many cycles. God forbid, if we go into a cycle like that, we're going to have that same playbook. (CEO Adam Norwitt 4Q15 CC)

Diversification strategy enabled by operating structure: One of Amphenol’s greatest assets is its diversification. The company seeks to be ubiquitous as new technologies are deployed and incremental operations are electrified, and diversification allows the company to always ‘be’ where the innovation is most apparent (i.e. 5G mobile devices and networks, the rise of cloud computing, IoT in Industrial, proliferation of electronics in autos, the digitization of the military, etc..). It also reduces the impact of idiosyncratic risk in any one vertical on consolidated results. This has resulted in a balanced mix across eight different end markets each of which are <20% of sales.

Despite the obvious benefits of diversification, it is not easy to execute well. We think Amphenol’s unique operating structure is what allows and encourages such diversity. Each market Amphenol plays in is inherently different and requires unique skillsets. Product cycles for mobile devices are extremely fast and require immediate response and scale, whereas auto/industrial trends are slower as the technology is spec’d into multi-year build schedules. It can be challenging for traditional companies to compete effectively in each vertical, and many have chosen to focus on areas of expertise (e.g. TEL divesting its mobile business to Commscope in 2015 to focus on the transportation and industrial sectors).  

Consistent M&A strategy provides additional leg of top-line growth for the company: APH has a long history of strategic, bolt-on M&A, acquiring on average +6% in annual revenue growth since 2005. Since 2011, Amphenol has acquired 35 companies with an average revenue per company acquired of ~$70mn.

Amphenol views itself as the acquiror of choice in the industry and sees acquisitions as the best use of its capital alongside new product development. Unlike a lot of companies engaging in M&A, APH focuses on cultural fit and technology over the multiple paid on near-term results. Management’s goal is to find companies with strong managers, good technology, and complementary market positions that have potential to do more under the Amphenol umbrella, and then develop a long-term relationship with these companies over time. And when these companies are ready to sell, Amphenol is more than happy to pay a fair price based on the cash earnings a company is delivering. 

Once acquired, APH believes it can increase sales and profits by opening the newly acquired business up to new markets, geographies, and customers, giving the business access to its supply chain, and through the sharing of best practices among GMs. Its track record of strong returns on capital and steady margin expansion despite consistent M&A supports this view.

Notably, APH has funded its acquisition program primarily through cash flow and the modest use of leverage. Since 2003, net leverage has averaged just 1.1x EBITDA (range: 0.2x to 2.2x) despite the completing almost $6bn in acquisitions, spending $2.4bn on capex, and returning $6.6bn in capital shareholders via dividends ($1.4bn) and share buybacks ($5.2bn). This suggests to us there is no financial reason that Amphenol’s M&A program would not continue to be a meaningful driver in the future.

Recent entrance into sensors has potential to be significant long-term value driver. Amphenol first entered the sensor market in 4Q2013 when it acquired GE’s Advanced Sensor business, and sensor companies have accounted for ~30% of subsequent acquisitions. Their strategic rationale for entering the market was that an integrated offering would prove a great selling point.

A sensor is a natural extension to interconnect; its job is to take a physical phenomenon and translate that into a digital signal which is then carried via an interconnect to its end point. With the proliferation of sensors into harsh environments (auto and industrial most prominently) and an increasing importance placed on minimizing size, APH had noticed that the sensor was usually getting integrated within the interconnect and felt that a unified offering would provide better performance.

The sensor market shares many similarities to interconnect. It is a large market, with a TAM (~$140bn) that is more than double global interconnect. The market has enjoyed strong growth supported by the proliferation of electronics, most notably in the automotive market where demand is being supported by mega-trends in connectivity, safety, sustainability, and automation that have the potential to quadruple content per vehicle over time. The sensor market is fragmented, served by large independents like Sensata and TE Connectivity (which also acquired into the market in the past decade), operating divisions of large industrial conglomerates, and smaller private sensor businesses that could increasingly be consolidated by larger sensor and connector companies. And the products sold are low $$ value components with a lot of technology embedded into it that goes into a higher value product.

The company does not break out sensor sales but based on disclosed revenue of acquired businesses and applying market growth rates, we estimate sensors is now a $800mn business (~10% of sales). Assuming APH can continue to execute on its organic and inorganic growth strategy, sensors have the potential to be a meaningful driver of growth and shareholder value over time.

Potential for strong earnings rebound as cyclical headwinds abate, M&A resumes: Last year was an uncharacteristically tough year for Amphenol as the company was caught in the cross current of trade headlines which negatively impacted several end markets. The company was negatively impacted by trade issues related to Huawei which reverberated throughout the tech supply chain and negatively impacted demand in IT and Datacom (19% of sales) and Mobile Networks (8%). It also was facing a difficult prior year comparison in the Wireless end market (13%). And at the same time, weaker than expected demand in global auto (19%) and industrial (20%) end markets were exacerbated by distributor inventory reductions. As a result, overall organic sales fell 3% on the year. In 2020, we expect further declines in organic sales related to Covid-19 challenges in ~60% of its end markets. Since peak levels in early 2019, consensus FY20/FY21 earnings estimates had come down 32%/22% - on par with declines during the GFC - before rebounding slightly after its 2Q results beat expectations.

Beyond 2020, the Street is modeling a rebound in 2021/2022, but the magnitude of the rebound appears to be light. After adjusting for the $550mn of acquired revenues since the end of 2018, consensus 2022 estimates embed minimal growth relative to 2018 results. This is inconsistent with APH’s experience in the last 2 cycles where sales surpassed prior peaks within a year of troughing and fails to consider prospective M&A which is almost a given considering their balance sheet strength and the disruptions that smaller, non-diversified private businesses have faced over the past year plus. Moreover, outyear margin estimates also appear light considering margins in 2019 were depressed by heavy acquisition activity and are likely to be further impacted in 2020 by lower volumes coupled with COVID-related safety spending. Given its historical success integrating acquisitions and driving overall margins higher over time, we would expect very attractive incremental margins as revenues improve, acquisitions are integrated, and COVID-spending subsides. Net-net, we see the potential for meaningful upside.

Valuation: At $110, APH is trading at 33x/28x/25x consensus FY20/21/22 earnings, which compares to its historical NTM P/E average of 20.6x (5-Yr average of 24x). On an EV-to-EBITDA basis, shares are trading at 19.9x/17.5x/16.3x vs. a historical average of 12.8x (5-yr average of 14.6x). On a normalized basis (Avg. FCF % ROIC x current invested capital), we estimate shares are trading at ~25x forward earnings.

Risk Factors:

·        Exposure to China/Global Trade. APH generates 73% of sales outside the U.S. and ~32% of sales in China. A large portion of its sales in China are to suppliers of electronics that make products for the rest of the world. Notably, APH’s decentralized model allows it to operate locally in all the markets/regions it operates in, and the company generally attempts to match up production with demand in given countries. This mitigates its exposure to tariffs and other trade disputes but does not eliminate the risks entirely to the extent the trade relations continue to deteriorate.

·        Further economic weakness. APH operates in cyclical businesses. It can offset the impact of cyclicality through diversification, organic growth/market share gains, and bolt-on M&A, but is not fully immune to the economy. To the extent the current recession deepens and/or a recovery fails to take hold in 2021, APH results would be negatively impacted.

·        Poor execution of organic or inorganic growth strategy. New product introductions, which Amphenol defines as products introduced in the past 2 years, are critical to driving sales growth and maintaining strong profitability, accounting for ~25% of revenues. To the extent the company misses out on latest trends in the electronics revolution or fails to acquire the right companies in growing verticals, its sales growth may disappoint.

·        Key man risk. Amphenol is lead by the very capable Adam Norwitt. He has been in charge since 2009 but is still very young (51) and has $300+mn reasons to want to continue leading the company. To the extent he was to leave to pursue another opportunity without grooming a successor, the leadership void would likely weigh on its premium valuation until the successor demonstrated as effective a communications and capital allocation acumen. 

Catalyst

Continued execution of their long-term strategy