Description

Commscope is a leading provider of communication and infrastructure equipment, serving large teleco carriers, OEMs, Enterprises and Cable MSOs. Mobility products represent 40% of sales and consists of RF network connectivity solutions and small cell/DAS solutions (20% of Mobility segment). Essentially, COMM makes "everything but the radio" with respect to wireless equipment that goes on cell towers. Connectivity products represent 60% of sales and consists of fiber (approximately half of this segment) and coax cable/copper and ancillary products. A large portion of the Connectivity business was acquired from TE Connectivity in 2015.

Thesis: COMM is nearly 13% off recent highs due to management's step-down of guidance for fiscal 2017. 75% of the revenue drawdown is a result of one-time/timing related issues. FirstNet is a large opportunity (over $250M in revenues potentially) which doesn't appear to be reflected in 2018 estimates. The completion of the international ERP implementation by year end should enable significant SG&A reductions and ultimately should enable 300 bps of SG&A reductions over next few years. Stock trades at a large discount on a P/E basis and that discount should narrow as the company continues to delever.

Guidance Draw-Down: Management reduced revenue guidance for fiscal 2017 by about $175M at the midpoint which is about 360 bps hit to topline growth. While clearly disappointing, most of the draw-down is one-time/temporary in nature. About $50M of the shortfall relates to a deferral of spending by AT&T as they are deferring a lot of tower-related capex spend until they deploy equipment for FirstNet. This makes a lot of sense considering towers generally charge fees every time an operator "touches the tower" to swap equipment.  It is much more cost effective for AT&T to defer capex until they can hit the towers at once with FirstNet. Timing is difficult to predict but it appears that FirstNet spending could start at the end of this year/early 2018.

Another $50M or so of the guidedown relates to some inventory de-stocking of fiber. Commscope and Corning are the two major suppliers of fiber which has experienced accelerating growth of late due to carriers' desire to densify their networks (small cells), support data growth and prepare for 5G. Over the past year both Corning and Commscope experienced supply constraints which led to some customers over ordering. Additionally, Google Fiber recently pulled back which, I suspect,  led to order cancellations. These dynamics led to a temporary slowdown in fiber orders as lead times normalize. This is really a temporary issue that will resolve itself in a quarter or two. The appetite and demand is very robust -- just listen to management from Dycom, Crown Castle, Uniti Group, Verizon, AT&T, Corning and Commscope to get a sense for the demand environment for fiber. FTTx represents about $1B, or 20% of COMM's business and I expect a multi-year growth rate of high single digits to low double digits.

About $40-$45M of the guide-down related to some issues related to the integration of BNS (the business acquired from TE Connectivity) that are temporary in nature. It is important to note that this acquisition has gone very smoothly over the past year and a half with cost synergy realizations ahead of original guidance. In this past quarter, though, COMM had some ERP implementation issues (fixed), some market share loss from consolidating brands and issues ramping fiber capacity due to poor yields (fixed). Given COMM's track record in M&A integration I am willing to give them a pass on one bad quarter of integration.

So that leaves about 25% of the guide-down that perhaps is a bit more structural -- COMM makes products to serve the data center market but is over-indexed to on-premise Enterprise Data Centers as opposed to hyper-scale or multi-tenant data center customers. One reason for this is because the latter group typically requires customized solutions and shorter lead times. COMM experienced an accelerated shift from Enterprise to multi-tenant/ in the past quarter and likewise took a hit given their lack of products to serve the non-Enterprise market. COMM is coming to market very shortly with products to address this. They have been working in conjunction with hyper-scale/multi-tenant data  centers to manufacture custom products that suit their needs. COMM's ability to make material progress here will take time but they are laser focused on this. The data center business does about $500M (10% of the total) with most of it serving Enterprise customers. So while it's an issue that needs addressing, its a small piece of the overall pie.

Catalyst

FirstNet: While the deferral of spend by AT&T was a negative and impacted guidance, this should be viewed actually quite favorably on a net basis considering the fact that FirstNet could add over $200M of revenues. I define the FirstNet opportunity as follows: AT&T will likely need to hit about 40,000 towers with 3 antennas each. Assuming $4000 price per antenna plus $500 in ancillary products, I believe the revenue opportunity is about $540M. COMM will not get all of this...in fact, I believe they will likely get about half with Katthrein (German antenna manufacturer) getting the other half. FirstNet spending will likely be front end loaded to the first two years and I expect this to start in 2018. Assuming 35% of the spend occurs in 2018 that would equate to $95M in sales and $.11 of EPS (assuming 35% incremental margins) to COMM. Likewise, FirstNet alone could add 500 bps of revenue growth to the Mobility segment and 400 bps of total EPS growth in 2018. Cumulatively, I expect FirstNet could add $.33 in EPS over the next three years.

This analysis doesn't include the fact that AT&T will likely spend additional capital on their network while deploying FirstNet and COMM pointed out about $50M hit this year from the deferral of spend on their own network. Likewise, we could see an outsized capex spend from AT&T with Commscope in 2018 which is not factored into the above analysis.

Margin Opportunity: COMM has a great track record of delivering on cost initiatives. Given the malaise from the quarter, the Street overlooked a very important statement on the earnings call from COMM's CFO regarding their objective to bring SG&A as a % of sales down to 13% from the current ~16% level. While this will take time (perhaps 2-3 years) it will be an important driver of future EPS growth. I believe COMM is running quite a few duplicative costs and shouldering the burden of a TE Shared Services arrangement during the ERP cut-over process. While the U.S. is complete, COMM will not cut-over the international ERP until the end of the year. I believe that will be the time when COMM embarks on substantial SG&A cost cuts. Legacy COMM enjoyed 13% margins but the BNS acquisition came with a higher SG&A cost structure which brought company-wide non-GAAP SG&A margins to over 16%. COMM believes there is no reason that SG&A levels cannot return to the 13% level although they have not provided guidance on when this will occur. Again, the final  ERP cut-over at the end of 2017 should be the catalyst. All things being equal, a 300 bps increase in margins equates to $.48 in EPS - a meaningful ramp relative to the $2.64 in EPS earned in 2016.

2018 Consensus Too Low: Consensus estimates imply revenue growth of about $200M in 2018 vs. 2017. If my thesis on FirstNet is correct, COMM should generate ~$95M of incremental revenues from FirstNet alone in 2018. Additionally, if AT&T deferred about $50M of spend from 2017 to 2018 as part of the FirstNet deployment, COMM could potentially achieve $150M of incremental revenues in 2018 just from AT&T  plus FirstNet deferrals. Fiber sales should grow 10% or so in 2018 which should add another $100M of revenues. In sum, assuming no growth anywhere else in the business, I believe AT&T/FirstNet/fiber sales alone should enable COMM to achieve incremental revenues in 2018 above consensus.

Earnings & Valuation: I estimate EPS of $2.75 in 2017 and $3.25 in 2018 (consensus is $2.75 and $3.14). My estimates assume a 35% tax rate and COMM would clearly be a beneficiary of tax reform (as would their customers). I believe COMM could earn $3.75 in 2018 if the tax rate dropped to 25%. My target price of $45 implies just under 14x 2018 earnings and about 10.5x EBITDA. By 2018 I expect net debt/EBITDA to be around 3.3x vs 3.7x at the end of 2016.

Risks: The mobility business is hard to predict quarter to quarter and so COMM could meaningfully miss (or beat) expectations in any given quarter. Customer consolidation could be an issue -- although Sprint spends very little with COMM, a merger of TMUS/S will not be a positive event for the stock. COMM's $500M data center business is experiencing structural headwinds due to shift to hyper-scale and they must react quickly to this dynamic. There is risk in their ability to execute and adapt to industry changes.