Description

Note: The memo below applies to COMM – we have posted under CM9, CommScope’s German ticker. Given the differences between our work and the write-up posted yesterday, we thought that the VIC community would benefit from the memo below.

Summary

CommScope is a high-quality, growing company in the communications equipment sector. COMM sells the physical media for communication signals: antennas and accessories for cell towers; copper and fiber cables; and jacks and panels for networks (including for commercial buildings, data centers and telecom infrastructure). The company sells capital equipment which makes the business difficult to project with precision in the near term. Over the long-term, COMM should benefit from continued rapid growth in data demand.

The company is composed of a number of complementary high-quality franchises. CommScope sells at the middle to high end in each of its markets, most of which have one or two primary competitors and sticky customers. COMM is largely protected from competition with Huawei and mostly insulated from the rapid price erosion inherent in selling electronic equipment.

Management has an excellent track record: they are clearly top-notch operators and have made several smart large acquisitions which turned into home-runs for shareholders. The business was taken public in 2013 by Carlyle, which gradually sold down its stake.

COMM is cheap: pro-forma for the acquisition of BNS from TE Connectivity (including tax benefits and synergies), the stock is trading at ~12x earnings, and ~10x EV/EBIT (with ~3.6x PF net leverage). We believe that the company can grow operating earnings in the mid-single digits and EPS in the low-double digits.

We believe the stock is a compelling risk/reward over the next 5 years.

The Businesses

The products that CommScope sells are generally a small portion of the overall cost of a network. While CommScope sells its products at a premium, it can lower the long-run cost of ownership by reducing labor costs and increasing reliability: it is hard to find the source of a problem in a large complex network, and expensive to replace. COMM has low cost-to-value products with high market share and one or two main competitors in each segment.

Mobility Solutions (~40% of EBIT, growing mid-single digits)

CommScope sells antennas, cabling, mounting hardware and related parts for cell towers, as well as Distributed Antenna Systems (“DAS”) and small cells. DAS and small cells provide wireless coverage in buildings. The bulk of the business came from the acquisition of Andrew in 2007. COMM's main competitor worldwide at the high end of the market is Kathrein, a German private company. While cell tower antennas are not cutting edge technology, COMM has been able to differentiate itself through a reputation for reliability and a long history of close partnership with its main customers. Many times CommScope is the only company at the table when a US customer is designing its roadmap. Like many of COMM’s other products, a faulty antenna is difficult to diagnose and expensive to fix: one tower climb might cost an operator $1,500-$6,000+ vs. $2,000-$10,000 for a new antenna (a cell tower upgrade would most often use 3 antennas). CommScope has the added benefit of being able to offer “everything but the radio,” while competitors do not carry a full range of products.

A number of other competitors sell antennas, including RFS (a division of Alcatel-Lucent) and Chinese manufacturers including Huawei. In the U.S., COMM has market share greater than 50%. Antennas are heavy and bulky relative to their value and must be assembled near their end-market to be cost effective. Antennas are also country or region-specific, since different places have different zoning requirements and frequency bands. COMM is the only manufacturer with the scale in the US to quickly and reliably supply a meaningful portion of the demand of the big carriers.

COMM’s other large product line for cell towers is cabling, especially hybrid power/fiber cables. The two main competitors in the market are Huber+Suhner and Rosenberger, which are Swiss and German, respectively. Cabling would seem to be a commodity product, but the connectors attached to it need to be highly reliable and can add significant value by reducing installation times. Generic cable, which has low penetration in high labor cost markets like the US, is the norm in low labor cost countries. Both H+S and Rosenberger operate with much higher cost structures than COMM, largely due to higher cost manufacturing.

COMM earns the substantial majority of its wireless profits from the US. Huawei sells antennas along with its radios in emerging markets and increasingly in Europe. Huawei antenna quality has improved and is now closer to COMM and Kathrein. However, Huawei is blocked from selling in the US because of national security concerns, which seem very likely to persist. 

Kathrein has long struggled in the US. In recent years, it has reorganized its salesforce and built a new factory in Mexico. While Kathrein has good technology overall, it doesn’t have the scale or the depth of relationships that COMM has in the U.S. Without the scale to profitably customize antennas to the US market, Kathrein is unlikely to take meaningful share from CommScope. Another promising data point which validates the defensibility of CommScope’s US wireless business is the failed entry of the Korean company KMW into the market after investing heavily in the effort.

COMM’s European business is less profitable than its US business, largely because Kathrein is the dominant incumbent and Huawei is an effective competitor. Although there is tremendous growth in cell infrastructure in China and other emerging markets, COMM and Kathrein have lower share in the developing world, with a few exceptions (for example, COMM has a good relationship with Qatari carrier Ooredoo, which buys COMM equipment even in Southeast Asia and other emerging markets). In these markets, COMM tends to sell a complete pre-connected tower top assembly called SiteRise, which enables carriers to install capacity without skilled labor.

COMM saw massive growth in its tower top antenna business from 2012-2014, due to the 4G rollout and share gains. While 2015 was down 20% and growth in 2016 was modest, over the long run mobile carriers are going to have to keep up their investment in wireless infrastructure in order to deal with the enormous growth in mobile bandwidth demand driven by mobile video. Cisco forecasts a ~47% CAGR in global mobile data demand from 2016 through 2021.

The investment required to add capacity to mobile networks is likely to keep demand for antennas high. Operators will need to add new locations and add a greater number of more complex antennas to existing towers (e.g. sector splitting and adding more links per antenna, a technique called MIMO). New frequency bands (600Mhz broadcast incentive auction spectrum and potentially more licensed and unlicensed spectrum in the future) will drive further antenna use. With low single digit growth in the number of cell sites and growth in the average revenue per cell site as antennas get more complex, the US tower top business is likely to grow in the mid-single digits.

The 4G rollout is still underway in Europe and ROW, and, over the long term, growth there could be higher than US growth, although the current environment is weak.

In addition to selling traditional cell tower equipment, COMM is the leader in Distributed Antenna Systems which broadcast cell signals in congested areas such as stadiums, hospitals, malls and airports. COMM has ~40% share in DAS, and the product line produces above average margins (DAS represents ~25% of mobility solutions revenue). The core DAS business of providing capacity to public venues is highly defensible: COMM has the largest installed base, and it needs to be upgraded continuously to deal with increased bandwidth. An incumbent upgrading an existing system has a near lock on the business.

In-building coverage product sales have grown rapidly and could accelerate if in-building coverage takes off in commercial office buildings (“the enterprise”), although there is more uncertainty in the enterprise segment than in the rest of COMM’s in-building business. In 2015, COMM purchased Airvana, a leading provider of small cells. Small cells serve the same function as DAS at a lower price but currently can only accommodate one carrier vs. several for DAS. Many industry observers expect DAS and small cells to converge over the next several years for office building applications. While enterprise penetration is hard to forecast, the in-building segment should grow faster than the macro tower solutions business.

A decline in microwave antenna sales will likely offset some of the growth in base-station antennas, cabling and DAS. Microwave antennas have long been used to provide backhaul from cell sites but struggle to accommodate the need for increased capacity and are increasingly being replaced with fiber connections.

Overall, the mobility segment should grow in the mid-single digits. Carrier investment in network capacity and quality is discretionary over the short term, which makes the business lumpy. While Verizon has a habit of spending capex relatively steadily, AT&T (COMM’s largest customer) has historically deployed its network in fits and starts.

The construction of FirstNet, a cell-network based US public safety system, is also highly likely to be a major opportunity for CommScope over several years. AT&T has for the time being cut back on its network capex while it waits for the states to complete the opt-in/opt-out process for FirstNet, in order to simultaneously deploy its over 60 MHz of “fallow” spectrum (AWS-3, WCS, and 700 MHz). When this process is complete (by late 2017), the ensuing opportunity for CommScope will be a significant multi-year build-out.

CommScope’s wireless business should continue growing even though carrier capex budgets aren’t likely to grow much. The company’s wireless sales aren’t highly correlated with carrier capex budgets since COMM only addresses 5%-10% of network capex. CommScope actively seeks to help carriers reduce their labor expenses, which comprise a significant portion of total capex. Further, the other components of the network, including radios and base stations, are likely to get cheaper because of several trends including network centralization and virtualization. In the future, carriers are likely to use commodity servers in centralized data centers rather than the expensive specialized equipment they currently use at cell sites.

Connectivity Solutions (~60% of EBIT, growing low to mid single digits)

Enterprise

The Enterprise business sells cables and connectors for office Ethernet networks and data centers. CommScope acquired the Systimax enterprise networks business from Avaya in 2004. Systimax had been AT&T's wiring business, which was spun out as part of Lucent. Systimax is the top brand for enterprise LAN Ethernet cabling systems: copper and optical fiber cabling, jacks, ports and receiving panels. COMM also sells a cheaper "fighter-brand" called Uniprise at the middle of the market, where competition is broader.

Ethernet cable specs are standardized but real-world performance varies significantly from provider to provider and even among batches from the same provider. Besides having a trusted brand, CommScope’s key selling point is uniform reliability, which it backs with a 20-25 year throughput guarantee for networks built entirely with COMM parts. For customers that care about the quality of their internet connection, such as financial institutions, it makes little sense to skimp on the initial wiring cost: labor costs for installation can be over 2/3rds of total project cost, so buying 10% more expensive cable is insignificant to the total cost. On the other hand, the risk from picking lower cost cable is meaningful: the customer could wire up an office building only to find that the Internet is running at 15mbs instead of the 50mbs it should be. The entire network often operates at the speed of the weakest link: the customer would have to test every length of wiring and connector in the building in order to find the culprits before pulling the offending wiring and re-installing it. COMM also benefits from having a large installed base: replacing any part of a network with a product from a new supplier voids the network warranty, and so it is unusual to replace part of a network with equipment from a non-incumbent vendor (especially in a data center). Copper wiring is heavy and production is mostly automated, so manufacturing in a low-cost country does not provide a cost advantage compared to local manufacturing because of transportation costs.

COMM has dominant share in the copper market, with ~25% share of cabling and ~35% share of connectivity (jacks, panels, etc.) world-wide. Share in the US in meaningfully higher. The market is very regional, so there are often several local competitors with meaningful share in any given market. On a global basis, however, COMM is the clear leader with 3x the share of the next largest competitor in cabling and 2x in connectivity. On the fiber connectivity side (the bulk of the fiber business), COMM is a close #2 to Corning, with ~25% PF global share to Corning’s ~35% and Panduit’s ~15%.

While selling Ethernet cables and jacks would seem like a commodity business, the segment has a leading brand, a sticky customer base, leading scale, and transportation cost dynamics which give overseas manufacturers a disadvantage. Chinese providers have tried to compete for years, but the business has held up well, which seems unlikely to change in the foreseeable future.

CommScope’s leading market share is a large advantage in the enterprise segment because of the power of distributors. COMM makes about half of its enterprise sales through Anixter, and another ~10% through Graybar. Beyond these, distributors are fragmented. While Anixter is an important part of the ecosystem with leverage over less differentiated suppliers, CommScope is able to “push” products rather than rely on “pull” from distributors because it has the scale to afford a large sales staff. Smaller manufacturers receive lower prices because they have to incentivize distributors and installers to push their products for them.

Enterprise LAN should be a steady business. Even though Wi-Fi has become ubiquitous, workstations in commercial offices are still generally wired with Ethernet. The number of jacks wired per workstation has been declining, however, and this trend will likely continue. Going forward, increased wiring for Wi-Fi and the shift towards higher bandwidth systems should largely offset the decline in workstation connections. Demand for LAN cabling systems is also cyclical: it is tied primarily to office renovations, as well as new office construction. The market experienced negative growth for several years post-recession but has recently returned to growth. Growth should be in the low single digits for the next several years given the recent strength in commercial construction. Growth could slow when the commercial construction cycles wanes. We assume the LAN segment is roughly flat over 5 years.

CommScope also sells into data centers, a market which should continue growing in the mid-high single digits. Though COMM has had difficulty selling into the faster-growing hyperscale portion of the data center market, management is taking actions to address holes in the product portfolio.

We expect low single digit growth for the enterprise business overall.

Broadband Connectivity

CommScope’s legacy business is selling mostly coax cable and some fiber cable to cable companies. The business is a duopoly with Amphenol that should be roughly flat over the next several years.  It represents ~5% of COMM earnings.

The largest business acquired by CommScope from TE Connectivity is connectivity for the last mile of fiber telecom networks (especially fiber distribution units and other connectors). The business is mostly a descendent of ADC, which TE acquired in 2010, but has bits from Raychem (a nice franchise in protective wraps) and AMP. About 75% of the business is related to fiber, and almost 25% is still related to copper. Corning is the leader in the business, followed by TE and Prysmian. Globally, the segment has ~16% share of the broader telecom connectivity network market to Corning’s 25% and Prysmian’s 12%, but higher share in certain geographies and products. In the US, the segment competes primarily against Corning, which is a good, price-disciplined competitor. The business has many of the attributes of COMM’s other segments (need for reliability, low cost compared to the entire system), but also benefits from IP protection.

Increasing penetration of fiber deeper into the network (i.e. FTTX) should continue to produce healthy high-single digit growth in the fiber business. Fiber to the home deployments have experienced strong growth and the existing backlog should continue to provide a tailwind. The bigger part of the business is adding capacity at the “community” level – i.e. reducing node sizes for MSOs and increasing backhaul to cell towers. The market is currently in a strong growth phase, as capacity constraints have caused problems for both COMM and Corning. However, the business has been cyclical over time: it was weak from the post-2001 bubble years through the crisis of 2008. Despite the cyclicality, increasing data consumption should contribute to revenue growth for many years to come.

CommScope inherited a declining central office copper business from TE, along with the growing fiber franchises. The business should continue shrinking at high single digit rates, with the drag diminishing over time. Overall, the broadband segment will likely grow in the low to mid-single digits.

Growth Overall

COMM’s business should benefit from rapid growth in data consumption for many years. Although the business can be lumpy, it should average low-to-mid single-digit growth over the next 5 years.

Synergies

COMM initially guided to $150mm in synergies from the TE BNS acquisition, and has since raised guidance to $200mm realized by 2018. Though the company has experienced minor setbacks in acquisition integration recently, the track record of the management team gives us confidence that these issues can be resolved.

Management

COMM management is excellent with respect to operations and capital allocation. CommScope earns much better margins than competitors in similar businesses (for example, COMM earns ~25%+ EBITDA margins in Enterprise vs. Corning at 18%, Belden at ~14% and TE at 9% in their networks business). Chairman Frank Drendel was one of the original “cowboys” of the cable business, starting the business from close to scratch in 1976. The business compounded at ~17% in the five years prior to the Carlyle buyout in 2011 (Carlyle has roughly tripled their money), and is up 90% since going public in December 2013. The TE BNS acquisition is management’s third “transformative” acquisition. The first two created a terrific amount of value for shareholders, and it looks like BNS will as well. Management hopes to keep finding deals. If they don’t find any attractive acquisitions, they intend to return cash to shareholders once leverage is down to 2x-3x EBITDA.

Conclusion

CommScope is a well-run, high-quality, growing business. The company operates in stable duopolies or tight oligopolies in most of its markets, and has been able to strengthen its position over time. At ~12x earnings (including synergies and the net present value of tax benefits), we believe the stock is significantly undervalued with a minimal risk of capital loss over a 5-year holding period.

Catalyst

-Continued strength in FTTX market

-Full realization of synergies from BNS transaction

-FirstNet-related spending by AT&T

-Progress on 5G initiatives by major carriers

-Improved international wireless spending

-Continued value-accretive M&A